
Class 

Book 



COPYRIGHT DEPOSIT 



Sound Investing 



SOUND INVESTING 



By 

PAUL CLAY 



A book for 



Estates 

Stock and Bond Dealers 

Business Proprietors and Partners 

Lawyers, Doctors and Professional Men 

Banks, Trust Companies and Insurance Companies 

Railroad, Industrial and Manufacturing Companies 

Colleges, Hospitals and Other Institutions 

Salaried Employes of Business Houses 

Clerks and Laboring Men 

Women and Dependents 

Trustees 



New York 
Moody's Magazine and Book Company 

1915 






\ 



<^\^ 



Copyright, 1915, by 

MOODY'S MAGAZINE AND BOOK COMPANY 

All Rights Reserved 



<$V&- 



JAN -5 1916 



CIA420250 



PREFACE 

The aim of this book is entirely practical. It is to 
offer directions to the uninitiated, to enlarge the under- 
standing of the small investor and to assist the experi- 
enced buyer of securities. 

Many of the subjects here treated were partly de- 
veloped by the author during the past two years under 
the general direction of Mr. John Moody, for Moody's 
Investors Service, a private publication, where they 
met with enough appreciation to warrant their further 
development into a permanent form. 

The author makes no attempt at profound or schol- 
arly discussion, but seeks only to set forth common- 
sense methods of avoiding losses, and increasing one's 
investment income. 

Paui. Ci,ay. 
New York, November 1915. 



(S) 



TABLE OF CONTENTS 



Section I: 

I. 
/II. 

/III. 

yiv. 

V. 



Section II 

VI. 

VII. 

VIII. 

IX. 

X. 

XL 

XII. 

XIII. 

XIV. 

XV. 

XVI. 

XVII. 

XVIII. 

XIX. 

XX. 

XXI. 

XXII. 

XXIII. 

XXIV. 

XXV. 

XXVI. 

XXVII. 

XXVIII. 

XXIX. 



The Use of This Book : pages 

Use of This Book 9 

Types of Securities 

Managing Investments S3 

Analysis of Values 39 

Personal Side of Investing 49 

Classes o? Securities: 

United States Bonds 53 

Other Government Bonds 61 

Municipal Bonds 67 

Railroad Mortgage Bonds 75 

Gas and Electric Light Bonds 83 

Equipment Trusts 95 

Street Railway Bonds 101 

Steel and Iron Bonds 107 

Short Term Notes Ill 

Bank Stocks 119 

Railroad Junior Bonds 127 

Equipment Company Bonds 135 

Manufacturing Company Bonds 139 

Copper Mining Bonds 143 

Coal Company Bonds 147 

Irrigation Bonds 153 

Light and Power Preferred Stocks 159 

Railroad Preferred Stocks 169 

Street Railway Preferred Stocks 173 

Industrial Preferred Stocks 179 

Mill Stocks 187 

Railroad Common Stocks 195 

Industrial Common Stocks 203 

Copper Stocks 211 

7 



8 



Table of Contents 



PAGES 

Section III: The Personai, Side of Investing: 

XXX. Investments for Stock and Bond Dealers 225 

XXXI. Investments for Banks, Trust Companies and 

Insurance Companies 231 

XXXII. Investments for Railroad, Industrial and 

Manufacturing Companies 237 

XXXIII. Investments for Trustees and Estates 245 

XXXIV. Investments for Colleges, Hospitals and 

Other Institutions 253 

XXXV. Investments for Business Proprietors and 

Partners 259 

XXXVI. Investments for Professional Men 265 

XXXVII. Investments for Salaried People 269 

XXXVIII. Investments for Clerks and Laborers 277 

XXXIX. Investments for Women and Dependents . . . 287 

Section IV: Practical Suggestions: 

XL. Finding the Desired Security 293 

XLI. Selection of a Bond House 299 

XLII. How and When to Buy and Sell 309 

XLIII. The Question of Yield ., 323 

XLIV. Uses of Securities 327 

XLV. Anatomy of Annual Reports 331 

XLVI. Feasibility of Successful Speculation 345 

XLVII. Bond Incomes 355 

Alphabetical Index 366 



SECTION I 
THE USE OF THIS BOOK 



Use of This Book 

THIS book is intended for reference. It should 
answer your question at a glance, and does not 
require to be read through in order to be use- 
ful to the reader. 

Those who wish to use it solely for reference can 
readily find any of the details treated by reference to 
the alphabetical index in the back, or possibly even to 
the table of contents. But those who are not familiar 
with the art of investing can get the most value out of 
the book by proceeding about as follows: 

First, peruse the three chapters in Section I. to 
obtain a general idea of the different classes of stocks 
and bonds, of the merits and characteristics of each 
class, and of the best methods of handling securities 
with a view to obtaining the largest possible yields and 
profits consistent with safety. 

Second, the investor, especially if inexperienced, 
should observe in the table of contents under Section 
III. to which of the ten classes of persons he belongs, 
and read the chapter upon his particular class. In this 
way he may find what kinds or types of stocks and 
bonds are most likely to satisfy his own peculiar or 
personal needs. 

Third, having learned what types of securities he 

(9) 



10 Sound Investing 



wishes to buy, the next step is to peruse the descrip- 
tion under Section II. of each particular type selected. 
If, for example, he has decided upon the purchase of a 
short term note, he will be interested in observing the 
general distinctions between safe and unsafe notes, and 
the peculiar merits of notes as a class. Each chapter 
in this section gives detailed attention to the varying 
methods of analyzing different types of bonds, notes 
and stocks. 

Fourth, Section IV. is intended to answer the prac- 
tical every-day questions which the investor is bound to 
meet after he has decided what to buy. Among these 
are the questions where to find the particular security 
wanted, how to select a bond house or broker, how to 
buy or sell, what the stock or bond ought to yield, and 
how to make the best use of securities held for invest- 
ment. One short chapter is devoted to considering the 
feasibility of speculation; and in the back of the book 
is given a shorthand rough method of finding the 
approximate yields of bonds without buying expensive 
bond tables. 



II 

Types of Securities 

BROADLY speaking, the leading types of classes 
of securities are mentioned in this chapter in 
the decreasing order of their stability. Of course 
it is quite impossible to say that every municipal 
bond, for example, is more stable than every railroad 
mortgage bond; for on the contrary there are a great 
many exceptions. However, it remains true that the 
best municipals are superior to the best railroad mort- 
gages in point of security and stability, and that the 
various gradations of the former are likewise superior 
to corresponding gradations of the latter. From time 
to time, as industrial and financial conditions change, 
certain types of securities rise or fall in rank; but it 
is believed that the order here given will remain 
approximately correct for a considerable period of 
years. 

United States Bonds: To investors generally United 
States bonds are of little interest, since they yield only 
1^4 to Zy 2 per cent. Their greatest use is by national 
banks who deposit them as security for bank note cir- 
culation, or for government deposits. However, they 
are among the very best bonds in the world, and are, 
practically speaking, as good as cash. For the man 
who is indifferent to the matter of yield and does not 

(id 



12 Sound Investing 



wish to carry his surplus funds in banks, these are just 
the thing. Even in the panic of 1907 they depreciated 
only about 5 per cent. — from which they quickly 
recovered. 

Other Governments: Next in the order of stability, 
in this country at least, are the bonds of the various 
states. These yield from 3^4 to 4^4 per cent, and are 
generally better than most of the bonds of foreign gov- 
ernments. The great mass of the burdens of govern- 
ment in this country fall upon the United States Gov- 
ernment, and upon the municipalities and minor civil 
divisions — so that the states are left with only very 
small debts and their obligations are accordingly gilt- 
edged. It is only a few of the oldest and most stable 
foreign governments, such as those of Great Britain, 
France, and Germany, whose obligations are equal or 
superior to those of our states. In considering a for- 
eign government bond much attention must be given, 
first, to the character and permanence of the govern- 
ment itself; second, to the amount of its debts and the 
burdens of taxation ; and third, to the per capita wealth 
of the people. 

Municipal Bonds: The obligations of American 
municipalities yield all the way from 4% to S% per cent, 
varying according to the condition of the bond market, 
and the investment standing of the particular munici- 
pality. In the panic of 1907 these bonds generally fell 
about 11 per cent., in comparison with 5 per cent, for 



Types of Securities 13 

United States bonds, and 7 for state issues. As a 
class, they are less secure than either, but still rank away 
up among the gilt-edged types of securities. 

Many of our municipalities are rushing into debt with 
extravagant disregard for the future, and not a few of 
them are so corrupt politically as to injure their own 
credit. There have been but few instances of default; 
and upon the whole defaults with these bonds are always 
improbable. Nevertheless, the growth of city debts has 
wrought a great change during the past ten years in 
the general position of municipals. Formerly they 
ranked far ahead of railroad mortgages, and yielded 
about 1 per cent, less ; but now there is very little differ- 
ence in intrinsic merit between underlying railroad 
mortgage bonds and the best municipals. 

These are reasons, not for avoiding such issues, but 
rather for using discretion in purchasing them. Some 
of them are as good as state bonds, and better than 
many foreign government issues. The obligation of a 
municipality, whose population, wealth and business are 
growing with more than average rapidity, and whose 
government is not unusually corrupt, is always desir- 
able. By sharp watching the investor sometimes has 
the opportunity to obtain a very good municipal bond 
on a 5 per cent, basis ; and it would be difficult to obtain 
such yield with equal or greater safety of principal in 
any other way. 

Raidroad Mortgage Bonds: Excepting government 



14 Sound Investing 



securities railroad mortgages still rank at the top of the 
whole investment list, and there is no probability of 
their being superseded in this position by any other type 
of bond. They are better secured by assets than most 
of the gas and electric light issues, and their earning 
power is less subject to municipal interference than 
either lighting or street railway obligations. In panics 
they usually fall 10 to 16 per cent., but this is due more 
to the forced liquidation that occurs at such times than 
to any real lack of intrinsic merit. 

There are naturally all sorts of mortgages from the 
underlying first liens, which have behind them from 150 
to 500 per cent, in physical assets, to the second or 
third liens which are scarcely covered by assets. The 
best bonds are of course those secured by underlying 
first liens; and these yield from 4% to 5 per cent, in 
ordinary times. They are a good cash equivalent, and 
are generally as safe as money deposited in almost any 
bank. 

Gas and Electric Light Bonds: The obligations of 
gas and electric lighting companies are high grade as 
to both security and stability, notwithstanding a rather 
general lack of information as to real assets and earn- 
ing power. Because of the fear of political attack, and 
of a widespread popular belief that public utility con- 
cerns are so rich that they can stand deep cuts in their 
revenues for the benefit of the public, it is seldom that 
they can afford to make detailed statements of earnings. 
To do so would be to invite trouble. 



Types of Securities 15 

Nevertheless their earnings are large and also fairly 
secure. In some cases the courts have held that they 
are entitled to a 6 per cent, net return on the capital 
invested, and that to reduce the rates for gas or elec- 
tricity below the basis of a 6 per cent, return would be 
confiscatory. During business depressions too, public 
utility earnings hold much better than those of either 
railroad or industrial companies. This stability renders 
these bonds attractive to the conservative investor, 
especially in view of the fact that they ordinarily yield 
from 4J4 to Sy 2 per cent. 

Equipment Trusts: These are secured upon the 
rolling stock of railways, and are usually issued for not 
more than 90 per cent, of the cash cost of such equip- 
ment, and paid off in about ten annual series. Because 
of this arrangement those which remain outstanding 
become more and more secure as time goes on. They 
remain a lien upon the entire original purchase of equip- 
ment, and therefore steadily appreciate in intrinsic 
merit. Railroad equipment retains its value no matter 
what happens to the road employing it, and for this 
reason equipment trusts or car trusts are very secure. 
Indeed they are more so than a great many gas and 
electric light bonds; and upon the whole it is rather a 
fine question which of the two should be ranked first. 
These trusts or notes depreciate during bear markets 
even less than mortgage bonds, taken as a class, 
although not less than underlying mortgages. They 
yield about 4^ to 5^4 per cent 



16 Sound Investing 



Street Railway Bonds: Upon the whole street rail- 
way companies are not financially strong. They do not 
carry large amounts of cash or current assets, and their 
revenues are very frequently the subject of political 
agitation. Hence it is that their bonds are semi-specu- 
lative. In buying them the investor needs to exercise 
a great deal of discretion, and to possess a knowledge 
of both the political temper of the community served, 
and the financial and physical condition of the given 
company. Some of the essentials are that the bond 
should show a large excess of available earnings over 
interest requirements, that yearly outlays for mainte- 
nance and depreciation should be sufficient to keep the 
property from deteriorating, and that the terms of the 
franchises should be satisfactory. Among street rail- 
way bonds some of the underlying issues are very high 
grade— -a few of them ranking even ahead of gas and 
electric light bonds. As a class, however, these issues 
rank in the order here given and yield about 4^ to 6^4 
per cent. 

Steel and Iron Bonds: These at present are among 
the very best of our industrial securities. The steel and 
iron business, although necessarily somewhat speculat- 
ive because of the radical fluctuations in the demand for 
steel, has been developed in this country to a point 
where there is no longer any doubt as to its perma- 
nence or as to the genuine value of bonds conservatively 
issued against physical assets. Even tarifif changes can- 
not threaten any such bond. The guaranteed issues 



Types of Securities 17 

of the subsidiary companies of the United States Steel 
Corporation are especially attractive, in spite of the 
absence of separate statements regarding the earnings 
of the issuing companies; and this is why they usually 
sell at prices which show only moderate yields. In 
general the bonds of steel and iron companies yield 
from 4^4 to 6% per cent. 

Short Term Notes : The better grades of short term 
notes are among the best securities which the conserva- 
tive investor can find, but much discretion must be used 
in determining which are the better grades. Note 
issues have so increased that they now constitute about 
one- third of all the security issues in the United States, 
excepting stocks; and there are constantly available a 
substantial number of notes to choose from. They are 
not as secure in law as many of the bonds mentioned 
above, but in practice their degree of security is greater 
than in theory. They are ordinarily issued in relatively 
small amounts, and run for only short terms of years; 
and for both reasons there is no real risk in buying the 
note of any corporation which is in a sound financial 
condition. It is the notes which show excessive yields 
that must be avoided; for as a usual thing the high 
yields denote a weak financial condition. Then, too, 
some corporations have adopted the very bad habit of 
issuing notes in large amounts — large, as compared with 
both annual earnings and total capitalization. Good 
notes seldom yield more than 6% per cent., and often 
they do not yield even 5 per cent. 



18 Sound Investing 



Bank Stocks: In this term is included the stocks, 
not only of national banks, but also of other banks and 
trust companies. The security behind these is not very 
high — by which is meant that their value depends to 
such a large degree upon sound management, and is 
disclosed to such a small extent by balance sheets and 
income accounts, that the general public is hardly quali- 
fied to invest in them. They are more suitable as invest- 
ments for wealthy men who are in close personal touch 
with the banks whose stocks they are buying. Broadly 
speaking, they are less secure than corporation notes 
because prosperous banks seldom liquidate, while un- 
prosperous ones are scarcely ever able to pay their 
stockholders anything more than par. Meantime almost 
every good bank stock, because of its earning power, 
sells considerably above par. 

As a class, these stocks yield only 3j4 to A T / 2 per cent, 
on their price; but the large investor, who is in close 
touch with the affairs of a number of banks, frequently 
has the opportunity to make big profits by purchasing 
the stock of a bank whose deposits are on the eve of 
making large gains. Any great increase in deposits is 
fairly sure to be followed by a corresponding increase 
in earnings and dividend payments. Thus it is that 
bank stocks sell at prices which are hardly warranted 
by their average income, and have come to be considered 
as "rich men's investments". 

Railroad Junior Bonds: Among these are all of the 
many varieties of railroad bonds which are not fully 



Types of Securities 19 

secured by assets. To be "fully secured" means to have 
enough assets behind them so that in the event of a 
foreclosure sale the bondholder would receive par. The 
principal types of junior bonds are second and third 
mortgages, collateral trust issues, convertibles and 
debentures. Because of the great variety of these types 
their yields vary all the way from 4^4 to 6 per cent. In 
buying them it is necessary to use a great deal more care 
and discrimination than in the purchase of first mort- 
gage bonds. 

Convertibles are bought primarily for their promise 
of profit on the principal; but this promise has been 
widely overestimated. In order for such a profit to be 
obtained, the stock into which the bond is convertible 
must rise and sell substantially above the conversion 
price. In other words, the value of the convertible privi- 
lege often depends upon an expected increase which 
never occurs in the value and price of the stock. Some 
railroad convertibles, however, are so well secured as to 
principal that they can well be bought upon the theory 
that if the stock does go up they will show a consider- 
able profit, while if the stock does not go up they will 
remain fairly good investments. Before buying a con- 
vertible at a price which at all exceeds its value as a 
pure investment, one should closely study the earning 
power and prospects of the stock. 

Debenture bonds, and indeed some collateral trust 
issues secured by stock collateral, are practically noth- 
ing but promises to pay. For this reason they may 



20 Sound Investing 



fairly be regarded as if they were notes, and judged 
according to the excess of net earnings over fixed 
charges. The debenture of a railroad whose net earn- 
ings exceed its average fixed charges by less than 25 
per cent, should show a very high yield and may prove 
a poor investment even then. 

Equipment Company Bonds: Reference is here 
made to the bonds of companies engaged in the manu- 
facture of railroad or electrical equipment. The makers 
of railroad equipment have generally financed them- 
selves with stocks rather than bonds; and in the case 
of electrical manufacturing companies the merit of a 
bond is almost entirely an individual question. One 
important consideration is the distinct tendency for the 
margin of profit in the elecrical manufacuring business 
to decline. Because of this, large bond issues on the 
part of such a company would be an evidence of lack 
of conservatism. The business of such concerns as the 
General Electric, the Western Electric and the Westing- 
house Electric is not subject to such violent fluctuations 
as is that of the makers of railroad equipment; and 
therefore their bonds, other things being equal, should 
be somewhat higher grade. Bonds of this class are not 
numerous, and yield from 4^4 to 6 per cent. 

Manufacturing Company Bonds: Manufacturing 
business with but very few exceptions is subject to 
violent fluctuations. In a panic the typical manufactur- 
ing company suffers a loss of 20 to 60 per cent, in net 



Types of Securities 21 

earnings, as compared with 10 to 20 per cent, for rail- 
road companies. Manufacturing bonds, therefore, are 
ordinarily dangerous investments for all those who are 
not familiar with the branch of business in which the 
given company is engaged. It would be safe enough 
for a cotton manufacturer to buy the bond of a cotton 
mill, but it might be very dangerous for a lumber dealer, 
or drygoods merchant, or even for a banker, to buy the 
same bond. These latter individuals are hardly quali- 
fied by their business and associations to judge the 
earning power and stability of a cotton mill. 

Manufacturing companies do not, as a rule publish 
enough details as to either income or assets and liabil- 
ities to show whether their bonds are sound invest- 
ments; and therefore the buyer of such bonds is taking 
a leap in the dark unless he has special knowledge. 
These facts are well illustrated by the disastrous 
declines in Allis Chalmers 5s, International Steam Pump 
Ss and in many other manufacturing company bonds 
which were once considered high grade investments. It 
is nevertheless true that those who actually possess the 
required knowledge can obtain a handsome return vary- 
ing from Sy 2 to 6y 2 per cent, through the purchase of 
the bonds of strong manufacturing companies. 

Copper Mining Bonds: Bond financing has not 
been extensively used by copper companies, and there- 
fore there are not many of these bonds. In theory they 
are not safe investments because of the great un- 



22 Sound Investing 



certainty as to ore reserves and metal prices; but in 
fact they have proved to be excellent investments thus 
far, simply because copper companies have issued bonds 
only for a small fraction of their total assets. These 
bonds are often issued to secure capital for develop- 
ment work, and sold before any great earning power 
has actually been attained. Furthermore, they are 
almost always convertible into stock; and the great 
advance in a copper stock which occurs when the 
property becomes a large and successful producer, 
causes a similar advance in copper mining convertible 
bonds. The factors above mentioned prevent such 
bonds from being literally high grade investments; but 
thus far those who have bought them as soon as issued, 
and sold them during a bull market in the stock con- 
cerned, have made remarkable profits. 

Coal Company Bonds: Although the coal mining 
industry is one of the great businesses of the United 
States, coal company bonds have occasionally proven 
poor investments. This is due to the unscientific, or 
even careless manner, in which such bonds have some- 
times been issued. There have been cases where they 
have been issued and sold against entirely undeveloped 
property in amounts exceeding the actual value of such 
property. Such a security is not a bond at all, but 
merely a posibility of a future bond. For an investor 
to buy any bond issued against an undeveloped prop- 
erty, unless he fully realizes that he is taking a specu- 
lative chance, is entirely unwise. Coal lands very often 



Types of Securities 23 

are sold by speculators to the companies which intend 
to develop them at such high prices that the operating 
concern is unable to show a reasonable profit on its invest- 
ments. Nevertheless good coal company bonds are 
satisfactory investments, and yield from 4^ to 6% 
per cent. 

Irrigation Bonds: In the United States irrigation 
bonds have been a failure, even though there is no 
fundamental reason why they might not be perfectly 
good if issued in the right way. The trouble is that 
agriculture in this country is extensive rather than 
intensive, and that with extensive agriculture the value 
of the product per acre of land is not sufficient to induce 
farmers in any great number to pay the cost of irriga- 
tion. With intensive agriculture, where the annual 
growth per acre is worth from $100 upward, irrigation 
pays. In this country, however, intensive agriculture 
does not generally pay, because land is cheaper than 
labor. In 1899 the crops produced on all irrigated lands 
in the United States were worth in the aggregate only 
$86,800,000, whereas the irrigation systems cost $67,- 
700,000. 

Before buying a bond of this type, the investor should 
satisfy himself, through his own personal investigation, 
of these four points: 

(1) That the irrigation service is so necessary to the 
production of crops that it will not be discontinued by 



24 Sound Investing 



the farmers to such an extent as to destroy the profits 
of the company. 

(2) That the company owns a permanent and ade- 
quate source of water supply. 

(3) That the price received for the service is suffi- 
cient to be profitable, and that the company is neither 
under-estimating its operating costs or neglecting de- 
preciation charges. 

(4) That the irrigation works are not over-capital- 
ized, and that proper sinking funds are provided. 

Light and Power Preferred Stocks: The preferred 
stocks of gas light companies, or of electric light and 
power companies, are among the best of stock invest- 
ments whenever they are issued by conservatively 
managed companies. Once in a generation or so people 
so change their manner of life as to bring into existence 
entirely new industries, and this is one of the instances. 
Prior to 1890 electric light and power companies were 
of no great consequence; but from 1907 to 1912 the 
earnings of such companies in ten representative states 
showed an average increase of 61.77 per cent. 

The growing popular consumption of gas and electric 
light has given these companies a permanent and stable 
place among our industries; and the rapid increase in 
earnings has made their preferred stocks quite attract- 
ive. Such stocks yield from $y 2 to 6y 2 per cent, and 
display more stability during panics and depressions 
than the great majority of other stocks. The investor 



Types of Securities 25 

should, however, satisfy himself that the company is 
conservatively capitalized; that its franchises are satis- 
factory; that it is reasonably free from dangers of 
drastic reduction in the price of gas or electricity; and 
that the stock has an average earning power equal to at 
least 175 per cent, of its dividend requirements. 

Railroad Preferred Stocks: Notwithstanding the 
great progress which street railways and certain classes 
of industrial companies have made, it remains true that 
railroad preferred stocks are the best in this country, 
except some gas, light and power preferred issues. In 
a great many instances they are even superior to those 
of lighting and power companies. The reason for their 
high quality is to be found in the moderation with which 
they are issued, and in the wide margin of safety 
which they generally show. Even in 1910 there were 
in the United States only $1,403,488,842 in preferred 
railroad stocks outstanding as compared with $6,710,- 
168,538 common; and since then the ratio of preferreds 
to commons has been decreasing. These stocks in that 
year earned an average of 26.75 per cent, available for 
dividends against only 6.43 per cent, for the common 
issues. More recent statistics would not with equal 
fairness disclose their position since conditions in the 
railroad field during the past few years have been con- 
tinually abnormal. 

For the investor who is not satisfied with the yields 
of bonds these are very satisfactory, since their return 
averages between 5 and 6 per cent. There are times 



26 Sound Investing 



indeed, especially in panics, when they can be bought on 
a 6 T / 2 per cent, basis. The principal concern of the 
buyer should be to make sure that the property is well 
managed and to keep watch of the monthly earnings as 
reported by the Interstate Commerce Commission. 

Street Railway Preferred Stocks: As a class the 
preferred issues of street railways are on a lower invest- 
ment plane than those of steam roads for a number of 
very tangible reasons. They do not generally earn as 
much, are more heavily capitalized, and are more fre- 
quently subjected to really serious governmental inter- 
ference. Of the three principal classes of governments 
in this country the United States government is the most 
serious, responsible and regardful of property rights ; and 
the municipal governments are as a rule the least respon- 
sible. Hence it is a disadvantage of street railways that 
they are directly subject to the latter. 

In normal times the gross earnings of railroads are so 
large in comparison with capitalization as to be equiva- 
lent to about 16 per cent, thereof ; whereas those of street 
railways are equivalent to only 11 or 12 per cent, of total 
capitalization. Correspondingly, street railway net income 
averages only 4 or 5 per cent., while that of steam railroads 
used to average 5 or 6 per cent. The two are about 
equal in net income, but the steam roads earn about one 
and a half times as much on their preferred stocks as the 
street railways. It is therefore wise in purchasing a pre- 
ferred issue of the latter to be familiar, not only with 
the earnings and condition of the property, but also with 



Types of Securities 27 

its franchises and with the political complexion of the 
municipality. The yields vary widely from 5*4 to 6^4 
per cent. 

Industrial Preferred Stocks: Still greater are the 
elements of uncertainty in the preferred issues of indus- 
trial companies. It is simply impossible to invest wisely 
in these stocks without first acquiring by thorough study 
a genuine knowledge of the conditions of the industry 
in which one is going to make an investment. A great 
many people, for example, during the boom in fertilizer 
consumption in this country a few years ago, bought the 
preferred issues of the fertilizer companies, supposing 
them to be high grade and stable investments. They 
were totally unaware that fertilizer consumption was 
bound to slump, and that the position of these stocks was 
certain to be hurt thereby. There are in like manner 
peculiar individual conditions which effect steel and iron 
stocks, and those of lead companies, oil companies and 
leather companies. 

Neither is it safe to put one's faith in the safeguards 
which are often embodied in the restrictions under which 
these stocks are issued. Such restrictions, when a com- 
pany becomes embarrassed, usually fail to protect the 
stockholder, and many of them indeed are more technical 
than real. Practically the only genuine safeguards are 
moderate capitalization, large earning power, conserva- 
tive management and a thorough knowledge on the part 
of the investor of both the industry and the company in 



28 Sound Investing 



which he is interested. The general yield is 5^ to 7 
per cent. 

Mill Stocks: The stocks of cotton and woolen mills 
owe their investment position, which is fairly high, 
purely to their good management. It is the general 
policy of these companies in very prosperous years to 
make only slight increases in their dividends and save 
the balance to use in paying dividends in lean years. 
Besides this, the capitalization of most mills is relatively 
small and fairly conservative. For these and other 
reasons mill stocks have never become speculative foot- 
balls, and they fluctuate within a pretty narrow range of 
prices. In view of the character of the business, which 
is subject to violent fluctuation of earnings, this is not 
only surprising but also complimentary to mill manage- 
ments. 

In the panic of 1907 New England mill stocks gen- 
erally depreciated but little more than half as much as 
New York railroad stocks. Yet it is seldom that any 
large class of mills ever shows earnings of much more 
than 5 per cent, per annum. Dividend payments vary 
between 2 and 6 per cent, per annum as a rule, and the 
stocks sell at such prices as to show a normal yield of 
4^2 to Sy 2 per cent. 

Railroad Common Stocks: There was a time a few 
years ago when the presumption was that the common 
stock of almost any American railroad either had, or 
soon would have, substantial intrinsic value. Such how- 
ever, has been the drastic decline in earnings since 1910, 



Types of Securities 2d 

that this presumption has disappeared. It has now be- 
come the part of folly to purchase such a stock without 
first examining both its earnings and its capitalization. 
The average earning power of these issues after rising 
from 1.81 per cent, in 1897 to 6.72 in 1906, has since 
fallen to 4 per cent. 

Conditions in the railroad industry have been distinctly 
unfavorable to the common stocks and are only begin- 
ning to change for the better. The margin of profit in 
the business has been narrowed down to such an extent 
as to make stock financing generally difficult; and in 
consequence bond and note financing has been so much 
used that interest charges absorb a large part of the earn- 
ings which were formerly available for dividends. There 
are still a large number of common railroad stocks which 
are good, although semi-speculative, investments. Their 
yield varies from Sy 2 to 6^4 per cent, and for those who 
can afford to take some risk they are desirable, espe- 
cially if bought in the midst of bear movements. 

Industrial Common Stocks: Industrial preferred 
shares and mill stocks are the lowest classes of issues 
that can properly be termed investments as distinguished 
from speculations. Individually there are common stocks 
of both railroad and industrial companies which have 
such long dividend records and such large earning power 
that they are not at all speculative; but this is by no 
means the general rule. The buyer of a common stock 
has no guarantee of dividends other than the probabil- 
ities, first, that they will be earned; second that they 



30 Sound Investing 



will be saved to the stockholder through wise manage- 
ment; and third that the directors will see fit to vote the 
payment of such dividends. There is no obligation on 
the part of a board of directors to maintain common 
dividends, and no way that the minority stockholders 
can compel them to do it. 

All this applies with special force to the typical indus- 
trial common stock. Such a stock may or may not have 
any physical assets behind it, and may or may not repre- 
sent any actual money investment on the part of its orig- 
inal holders. The features to be desired in it are steady 
earning power, stability of price, a long dividend record 
and a conservative management. The management must 
be judged largely by the statistics of earnings, assets 
and expenditures given in its annual reports. These 
stocks yield from 5^4 to 7y 2 per cent., but each of them 
should carefully be examined before purchasing. 

Copper Stocks: As investments, in the literal mean- 
ing of words, copper mining stocks are approximately 
at the bottom of the list. At least they rank lowest in 
stability of price, of dividend payments and of earning 
power. There is no such thing as making a copper stock 
investment so reliable that it does not need watching, 
simply because it is humanly impossible to control the 
underground conditions. If an ore body, even after 
lasting for generations or centuries, at last gives out, 
then the stock of the company is bound to slump no mat- 
ter how conservative and efficient the management may 
be. 



Types of Securities 31 

These stocks, therefore, are distinctly speculations and 
should be bought for their rise in price, rather than for 
their dividends. The man who habitually and continu- 
ously buys them for their dividends and holds them, 
and does this with a substantial number of the stocks of 
different copper companies, is apt to be a loser. But he 
who buys in bear markets after railroad stocks have 
dropped 19 per cent, or thereabouts and copper stocks 
from 30 to 50 per cent. — not points— is pretty sure to 
make money. To do so he must sell out in the next bull 
market, invest his funds in high grade securities and 
await another slump before repurchasing coppers. Never- 
theless copper stocks handled in this way show huge 
returns; and if this method is persistently adhered to, 
in spite of the temptations to buy when prices are up to 
or above their average level, there is very little risk in it. 

General Observations: In these descriptions of vari- 
ous classes of securities, it is certainly not intended to 
discourage the purchase of any. The purpose of point- 
ing out the weaknesses and defects is invariably to enable 
the investor to make wise selections, and not to drive 
him away from the given type of stock or bond. Invest- 
ments in any class of securities here mentioned will pay 
if handled aright; and it would be a complete mistake 
to place any security under the ban simply because it 
happens to belong to some particular class. 



Ill 

Managing Investments 

REAL management of investment accounts is gen- 
erally lacking. By this it is meant that the pre- 
vailing practice, after having made an investment 
purchase, is to keep the given stock or bond in one's 
safe deposit box until it matures, or else until need of 
money or alarm over the business position of the com- 
pany which issued the security, induces the investor to 
sell it. Changing or shifting one's investment list from 
time to time to suit the condition of the financial mar- 
kets is unusual, and yet very profitable. No doubt 
the persistence with which the public holds a cer- 
tificate once bought is a good thing for borrowing 
corporations, and tends to give greater stability to 
security prices. Yet a little reflection will disclose 
the fact that to refuse to change one's holdings in ac- 
cordance with the varying position of the stock and bond 
markets is to neglect a very valuable opportunity. To 
bring out this point let us notice some of the changes in 

recent years in stock and bond prices. Representative 

R. R. securities 
Bonds Stocks 

Prevailing prices in August, 1896 73.88 41.82 

Thence occurred a rise to the spring of 1899 94.44 84.92 

From there prices declined to Sept., 1899 88.74 72.48 

The next high points were in 1902 99.53 129.36 

The low records of 1903 were in October 85.93 88.80 

Ensuing bull market ended in 1905 and 1906 at. . 99.16 138.36 
In the panic of 1907 prices were lowest in Nov.. 80.99 81.41 

The next bull market culminated in 1909 94.30 129.% 

In the war panic of 1914 prices were again down 79.75 87.40 

(33) 



34 Sound Investing 



Both of these averages are based on lists of twenty 
securities, and the bonds taken are all mortgage bonds, 
although not of the very highest grade. These move- 
ments are quite sufficient to show that the swings of 
prices in bonds, to say nothing of stocks, are very wide. 
If it were possible to buy stocks close to the bottom, and 
sell them close to the top, a very small investment would 
soon make one rich, even though he allowed his money 
to remain absolutely idle during all the periods of de- 
clining prices. Even a bear market of two or three 
years duration would use up in loss of dividends and 
interest only a small fraction of the profits made in the 
previous bull market. 

But unfortunately it is wholly impossible to either 
buy at the bottom or sell at the top. Hence the attempt 
to do so is not worth while; but the investor can never- 
theless do the next best thing. He can so manage or 
shift his investments from one class of securities into 
another as to get a large benefit from the bull markets, 
especially in stocks and as to suffer small injury from 
bear movements. To do this, it is not necessary that he 
should have the superhuman discernment to pick either 
the top or the bottom of a movement. All that he re- 
quires is enough commonplace discretion to know when 
securities are dear and when they are cheap. When 
they are dear his policy should be to withdraw from his 
safe deposit box such stocks, notes and bonds as would 
be likely to depreciate most; sell them, and replace them 
with high grade low-return municipals, governments and 



Managing Investments 35 

the like, which depreciate the least. That such an opera- 
tion is well worth while may be seen from the following 
comparison of the percentages of shrinkages or depre- 
ciation of various securities during the bear movement 
and the panic of 1906 to 1907. 

United States bonds 5.0% 

State bonds 8.0 

Municipals 11.0 

Railroad underlying liens 12.5 

Railroad bonds 15.7 

Bank stocks 24.0 

Industrial bonds 24.0 

Railroad pfd. stocks 28.5 

Industrial pfd. stocks 34.0 

Mill stocks 22.0 

Railroad common stocks 41.0 

Industrial common stocks .... 48.5 
Mining stocks 64.2 

To take the most extreme illustration of the profit to 
be obtained by shifting investments rather than holding 
the same securities regardless of the swings of the 
market, let us suppose that a man who had invested all 
his money in mining stocks had early in 1907 sold them 
all and put the money in United States bonds. He would 
have made the exchange at a time when copper mining 
stocks in particular were yielding 5 or 6 per cent., and 
United States bonds scarcely 3 per cent. Such a loss of 
income would deter most any man from making the ex- 
change ; but had it been done, and had he suffered the 3 



36 Sound Investing 



per cent, loss of income for a whole year, his saving for 
the year would still have been equivalent to 56 per cent, 
of his entire capital. Otherwise expressed, United 
States bonds shrank 59.2 per cent, less than copper 
stocks — so that the loss of every dollar of current in- 
come was rewarded by a saving of $19.00 in the value 
of his principal. 

In actual practice the largest possible saving would be 
very much less than this, and yet it is well worth the 
trouble. Manifestly there is no way to tell when a bull 
or a bear movement is going to end. Hence the exact 
time to make such exchanges of securities can never be 
determined; and since it cannot be, it therefore becomes 
a part of wisdom to gradually exchange from the less 
stable into the more stable securities as soon as stock and 
bond prices become relatively high, and to reverse the 
operation when prices are low. Low and high are very 
indefinite terms, but to one who watches the movement 
of any average of bond or stock prices, they are definite 
enough to serve the purpose. Averages of stock prices 
are published by almost every financial paper, and a few 
papers publish averages of bond prices. Indeed it would 
pay anyone investing more than a few hundred dollars to 
copy the prices of ten leading bonds each week, so as 
to have a record of his own to use in managing his in- 
vestments. 

When security prices become high, one should grad- 
ually exchange all his other investments into the first six 
to ten classes of securities mentioned in the Table of 



Managing Investments 37 

Contents under Section II. No hard and fast rule can 
be laid down, since there are numerous small classes of 
securities which are not here treated, and since there are 
individual bonds which, because of their great peculiar 
merit, are very stable, even though not included in any 
of the six classes just referred to. It nevertheless re- 
mains true that when one descends in the list below 
equipment trusts, he begins to encounter securities 
which as a class depreciate in a great bear market 
more than 15 per cent. The return on such securities, 
even though it be high, is not sufficient to compensate the 
owner for such a shrinkage. Indeed, when security 
prices become very high, as they were in 1902, 1906 and 
1909, it would be difficult to find any large class of se- 
curities, other than the above six, which are stable 
enough to meet the needs of the situation. 

When, on the other hand, a bear market has progressed 
for a year or more, and has carried railroad stock prices 
down a general average of 20 to 40 per cent., it pays to 
reverse the operation. One may then safely dispose of 
extremely gilt-edged securities yielding less than 4^4 per 
cent, and begin to buy short term notes, junior 
railroad bonds, manufacturing company bonds and 
even good preferred stocks. After real panics, such as 
those of 1893, 1896, 1907 and 1914, it is safe to invest 
a large portion of one's total funds in preferred stocks, 
and to place a small amount of money in common stocks. 
Surprising as it may seem, the appreciation in price of 
common non-dividend-paying stocks bought immediately 



38 Sound Investing 



after panics is so great as to more than offset the divi- 
dend payments and appreciation combined of really 
good standard issues. 

Much can be accomplished by this general method of 
management. It is not a new or radical idea, but merely 
a practice which has not yet become very widespread or 
popular. There is of course no such thing as a safe way 
to get rich quick ; but by shifting one's investments so as 
to increase the profits arising from a bull market, and 
decrease the losses consequent upon a bear movement, 
one's average yield can be greatly enhanced. With se- 
curity prices at their average level, it is practically im- 
possible to obtain an average yield of much more than 
53^ per cent, without assuming some considerable degree 
of risk. But if this method of management is followed, 
and followed with no more than ordinary intelligence, 
the average yield over any considerable period of years 
can be raised from 5j4 per cent, to 6 T / 2 or even 7 per 
cent. Indeed, if the investor is favored with a moderate 
degree of good fortune as well as good judgment, he may 
even bring his average up above 7 per cent. 



IV 

Analysis of Values 

A DETAILED discussion of the method of analyz- 
ing each class of securities will be found in 
the chapter on the given class. In advance, how- 
ever, one should consider the general methods of analyz- 
ing all securities. The public has a well-established 
habit of judging stocks and bonds like individuals by 
their references, or in other words, by what men in good 
standing say about them. This, however, is a mistake; 
for a person has a moral character which, practically 
speaking, does not fundamentally change from birth to 
death. A stock or bond on the other hand has no moral 
character, and often so changes its nature as to become 
entirely different from what it was during the period of 
years when it acquired its reputation. New Haven stock, 
for example, after being one of the very best railroad 
stocks in the United States or the world, suddenly in the 
course of a very few years became a pure speculation of 
doubtful value. Likewise, New York City bonds from 
1903 to 1910 changed their character from very gilt- 
edged to mediocre. The investing public, including 90 
per cent, of our most intelligent men, get in the habit of 
thinking a given security has a certain character; and 
when the security changes its character, they do not cor- 
respondingly change their opinions. 

(39) 



40 Sound Investing 



Neither is it proper to rely entirely upon the broker or 
bond house through whom one makes his purchase. If, 
instead of a bond, it were a piece of real estate, one 
would have the title examined, even though the seller of 
the real estate were a man of the greatest business judg- 
ment and the highest integrity. In like manner it is 
merely the exercise of ordinary prudence to analyze the 
merits of the stock or bond one is buying even though 
it be most highly recommended by the very best of bond 
houses. Indeed, it is negligence to fail to do so ; and the 
investor who commits such negligence should have no 
word of censure for the bond house, in case the stock or 
bond proves to be other than what he expected. 

There is no one method of analysis which can be ap- 
plied to all securities, because the securities themselves 
are so different in character. Aside from state and 
municipal bonds all other issues may be roughly divided 
into five classes, and each class has its own peculiar 
method of analysis. The first thing to do is to learn 
what is the "fluctuating principle" of the given stock or 
bond, that is, the principle or factor in accordance with 
which the price and value of the given security moves 
upward or downward. Further definition may be found 
in the introduction to the chapter on United States 
Bonds. Broadly speaking, the five classes of securities 
and the fluctuation principles of each, may be stated as 
follows : 

(1) There are absolutely secure bonds having be- 
hind them 150 per cent, or more in physical assets. These 



Analysis of Values 41 

remain good no matter what happens to the issuing com- 
pany, since they are certain to realize at least par even 
in the event of a foreclosure sale. Hence their price 
is merely a matter of yield or income basis. If the 
prevailing price of capital, which may be defined as the 
average yield demanded by the investing public, rises, 
then these bonds fall, and vice versa* 

(2) There are the practically safe bonds which have 
behind them more than 100, but less than 150 per cent, 
in assets, and which would probably, but not with abso- 
lute certainty, bring par in case of a foreclosure sale. 
These depend partly upon the price of capital, and partly 
upon the maintenance of the status quo, or existing con- 
dition of the company's affairs. Any radical change in 
capitalization, indebtedness, or management is liable to 
affect their value almost as much as a similar degree of 
change in the prevailing price of capital. 

(3) There are those securities which have behind them 
just about 100 per cent, in tangible or intangible assets, 
and which are therefore good investments, at least for the 
time being. These depend upon the earnings of the given 
company and upon the prevailing rates of interest in the 
money market. Interest rates affect stocks and junior 
bonds more than does the price of capital, because these 
junior securities are in competition with the borrowers 
of money. If a lender of money can obtain the higher 
return by buying commercial paper, or otherwise loaning 
to an individual, he is likely to do it ; but if he can obtain 
the higher return through the purchase of a good stand- 



43 Sound Investing 



ard stock or junior bond, he is likely to do that. Thus it 
is that interest rates directly affect this class of securities, 
whereas the price of capital has almost nothing to do 
with them. The latter is the yield which over a long 
period of years is satisfactory to the long-term investor, 
and interest rates are merely those rates which for 
periods of one day to six months are satisfactory to the 
lender of money. 

This class of stocks and bonds is also affected by move- 
ments of earnings. As they have behind them not much 
over 100 per cent, in assets, their holders cannot feel 
at all sure how they would fare in the event of a receiver- 
ship, and therefore they rely principally upon a constant 
and fairly large surplus of earnings over interest and 
dividend requirements. 

(4) Next in order are the securities which, while good 
as long as earnings remain within certain limits, are 
nevertheless somewhat deficient in assets. Among these 
are many notes, debenture and convertible bonds and 
preferred stocks. The movement of interest rates, of 
course, affects not only the third, but also the fourth and 
fifth classes of securities here mentioned; but with this 
fourth class the prime factor is earnings. These secur- 
ities do not rise at all proportionately as yearly earnings 
increase over and above 200 per cent, of dividend and 
interest requirements ; but they do begin to show distinct 
weakness when earnings begin to fall below 125 per cent, 
of such requirements. 

(5) Lastly, there are the pure equities which, if they 



Analysis of Values 43 

represent assets at all, have behind them not permanent 
physical assets, but rather fluctuating assets, such as bills 
receivable, bank loans, or treasury securities, and in- 
tangible assets such as good will, franchises and patents. 
These are mostly common stocks, but do include some 
notes and so-called bonds. They respond directly and 
almost proportionately in their price and value to the 
fluctuations of earnings. Furthermore, they are affected 
by everything that in any way affects the company. 

Having thus noticed the fluctuating principle of each 
of these main classes of securities, it is proper to observe 
the method of analysis to apply to each class. To mix 
the methods would lead to the wrong conclusion, or beget 
a total absurdity. For illustration, if one were to judge 
a bond, covered by a 150 per cent, of physical assets, by 
the fluctuations of earnings, he might conclude in the 
event of a slump in net profits that it was worth only 
60 per cent, of par, whereas in fact its true value might 
meanwhile have risen from 100 to 103 per cent, of par, 
because of a general decline in the price of capital. These 
methods then will be considered in the above order. 

(1) Manifestly what is needed in the case of a bond 
abundantly secured by assets, or presumed to be so se- 
cured, is first, some test of the assets ; and second, some 
knowledge as to the prevailing price of capital or income 
basis for other similar bonds. Assets cannot be judged 
by the balance sheets even of thoroughly reliable con- 
cerns. If an expert accountant were to set out to make 



44 Sound Investing 



the balance sheet of his comtpany exactly tally with the 
actual market value of all the assets possessed by any 
large company, he would have to employ an enormous 
force of engineers, appraisers and accountants ; and even 
then he would in fact be obliged to draw up a new bal- 
ance sheet every day, and sometimes several times a day. 
Balance sheets are then largely technical ; and sometimes 
this technicality consists in marking down book values to 
a mere fraction of actual market values, while at other 
times it consists of writing them up to 200 or 300 per 
cent, of actual values. 

Hence the average investor has no accurate test of 
assets, and must use the best makeshift he can. This is 
to be found by valuing the entire company, whether 
it be a railroad, or a public utility, or industrial concern, 
by means of the average prices of all its outstanding 
securities. Having obtained the aggregate actual market 
value of all these securities, he can then obtain the ap- 
proximate physical assets by making a proper deduction 
or allowance for the non-physical assets. For example, 
if he finds that the plants and permanent properties of 
other companies engaged in the same industry — com- 
panies enjoying a high reputation — are worth 75 per 
cent, as much as the grand total assets of such com- 
panies, then he can safely assume that by deducting 25 
per cent, from the aggregate average market value of 
the capitalization of the given company, he will obtain 
the approximate worth of its physical assets. To say the 
least, the use of such a method of estimating will save 



Analysis of Values 45 

him from buying bonds of poor quality in the belief that 
they are strictly high-grade first-mortgage bonds. 

(2) The same test should be applied to this class, 
and in addition the changes in its capitalization, current 
liabilities and margin of safety should be closely ex- 
amined to see whether the status quo is really being 
maintained. The significance of all these terms is ex- 
plained in Chapter 45, which deals with the anatomy of 
annual reports. 

(3) Analysis of the third class of securities should 
concern itself largely with the question of the genuine- 
ness of the net earnings shown. It is nothing unheard-of 
for companies of long standing and high reputation to 
occasionally issue an annual report made up in such a 
way, and so filled with technicalities, that it seems to 
show net earnings far in excess of the amounts actually 
earned. Upon minute examination it will always be 
found that such a report has made no actually false state- 
ments, but it is none the less deceiving unless closely 
analyzed. A dozen very prominent corporations in the 
United States have done this within the past five years. 
In testing the genuineness of earnings a principal point 
is to make sure that maintenance charges are sufficient 
to keep the physical properties from deteriorating. 

As the values of these securities are also much affected 
by interest rates, the investor in determining what price 
he should pay for them should take into consideration 
any distinct tendency of interest rates, especially in the 
New York money market, to either rise or fall. In ob- 



46 Sound Investing 



serving the course of interest rates, however, it should 
be borne in mind that money is normally high from Sep- 
tember to December inclusive, and normally at its cheap- 
est from May to July inclusive. According to ten- 
year averages, the mean rate for all money loaned in 
New York gradually rises from 3.63 per cent, in June 
to 5.83 in December, has a sharp fall in January, a tem- 
porary moderate rise to about 4.12 per cent, as an aver- 
age in March or April, and then falls again. Compari- 
sons of rates, therefore, should generally be made with 
the previous year rather than the previous month. 

(4) In considering the future of earnings the prin- 
cipal factors are changes in wages, margins of profit and 
prices. By prices is meant not only the prices at which 
industrial companies sell their goods or commodities, 
but also those at which a railway sells its transportation, 
or a lighting company sells its gas or electricity. The 
percentage of net earnings to gross over a series of years 
will usually disclose the tendency of margins of profit to 
become narrower or wider. Wages, even where the ac- 
tual figures are unobtainable, ordinarily respond to the 
prevailing tendency. The Steel Corporation, the Inter- 
national Harvester Company, and many other concerns 
publish every year figures showing their per capita 
wages; and the Interstate Commerce Commission gives 
similar data for railroads. It is safe to assume that the 
wages paid by almost any typical concern are moving 
in the same direction as those of these representative cor- 
porations. 



Analysis of Values 47 

(5) With common stocks and other pure equities, one 
must watch everything that throws light upon the course 
of earnings or the efficiency of managements. With 
railroads this means the monthly earnings as reported to 
the Interstate Commerce Commission, with steel com- 
panies it means the average prices of steel as shown in 
the various trade journals, the monthly exports of steel 
and iron published by the Department of Commerce, and 
the monthly statements of unfilled tonnage given by 
the Steel Corporation; and with copper companies it 
means watching the changes in the average prices of cop- 
per and in our exports, etc. The possessor of a common 
stock or any other pure equity can only prosper through 
eternal vigilance. In addition to these factors bearing 
directly upon the earnings of the particular company, 
he must watch the changes in the general prosperity, 
since these are certain to affect his company. The gen- 
eral prosperity in turn is best indicated by statistics of 
bank exchanges, gross railroad earnings, commercial fail- 
ures, merchandise imports and commodity prices. It 
takes a very wise man to analyze correctly the value of 
a common stock. Indeed, the difficulty of correct 
analysis from Class (1) to Class (5) steadily increases, 
and at a geometrical ratio. 



Personal Side of Investing 

FROM what has just been said about the increasing 
difficulty of investing profitably in the less stable 
classes of securities, it follows that the more one 
knows about stocks and bonds, the better qualified he is 
to buy common speculative stocks, preferred industrials, 
junior bonds and the like. Curiously enough, those who 
are least qualified are most in the habit of buying such 
securities, whereas those who are best qualified to handle 
the stocks and bonds which are difficult to analyze are 
the most in the habit of purchasing gilt-edged bonds 
which are thoroughly secured by a surplus of physical 
assets. 

This anomalous situation arises naturally from the 
training and experience of the two classes of people. 
One who has had a great deal of experience with invest- 
ing realizes the difficulty of foreshadowing the future of 
a common or preferred stock, a debenture bond or any 
other mere promise to pay. A person who has not had 
such experience is apt to believe that he can figure out 
the values of such securities, this belief being based upon 
his lack of acquaintance with a great many of the fac- 
tors that determine those values. The experienced inves- 
tor also makes it his primary aim to obtain safety of 
principal, as he realizes what constant watchfulness it 

(49) 



50 Sound Investing 



requires to keep possession of the savings of past years, 
but the inexperienced buyer is principally intent upon 
purchasing something that will start him on the road to 
fortune. His primary aim is a big yield, because he is 
unaware of the big risk that goes with such a yield 

In brief, such are the inconsistencies of life, that 
those who cannot afford to speculate are the ones who 
do it, and those who can afford it are the ones who 
avoid it. At least the former put into highly specula- 
tive stocks and bonds by far the larger proportion of 
their total savings. Any person, therefore, in investing 
his savings should take into consideration, not only the 
bond house through which he deals, and the particular 
security he contemplates buying, but also his own per- 
sonal qualifications for judging the values of securities. 

In the Table of Contents, in Section II. is given a list 
of the leading classes of securities in the decreasing 
order of their safety and stability, so far as this order 
can be readily determined. Now the less one knows 
about securities the more he should confine himself to 
those at or toward the top of the list; and the more he 
knows about them the safer he is in going after the high 
yields shown by those toward the bottom of the list. In 
Section III. of the Table of Contents is given a list of 
ten principal classes of investors, the most expert being 
mentioned first, and the least expert, approximately 
speaking, being mentioned last. One who finds that he 
belongs to a class of investors mentioned in the latter 
part of the list of persons should generally confine his 



Personal Side of Investing 51 

purchases to the securities toward the top of the list of 
investments. Furthermore, as skill in judging stocks 
and bonds depends at least as much upon experience as 
upon mental capacity, one should not be too hasty in 
assuming that he is better qualified than the rest of his 
class. 

To take a concrete illustration, any clerk or laboring 
man, however unacquainted with securities, is entirely 
safe in buying a United States bond, and is fairly safe 
in buying almost any bond belonging to any of the first 
six classes mentioned in Section II. If, however, in an 
attempt to tread the road to w T ealth, he spends his sav- 
ings freely for common industrial stocks and mining 
stocks he is pretty likely to lose from 50 to 90 per cent, 
of his savings. Nothing requires more expert skill than 
to tell the difference between a good and a bad mining 
stock, especially if the stock be unlisted on any reputable 
exchange. 

For these reasons the chapters in Section III. are de- 
voted to suggestions as to what classes of securities dif- 
ferent classes of people may wisely invest in. Further- 
more, some rough suggestions are made for those who 
desire information as to the approximate percentage of 
one's total fund which may well be put into each class of 
stocks or bonds. It is recognized, of course, that stock 
and bond dealers are quite capable of handling their 
personal investments without any such suggestions; and 
yet a great many of them are inclined toward a degree 
of conservatism, which to them is unnecessary, and 



52 Sound Investing 



which results in reducing their average percentage of in- 
come below what men of their ability and experience 
ought to be able to obtain. Therefore, without any pre- 
tence of superior knowledge or dogmatic certainty, the 
writer ventures these suggestions for all classes of people 
from highest to lowest. 

The gradation of these classes of people or investors 
is, of course, merely approximate. There are for ex- 
ample, numerous trustees of estates possessing greater 
knowledge of stocks and bonds than numerous stock and 
bond dealers. Yet it is probably true that these dealers 
as a class have a deeper understanding of securities than 
the trustees of estates. It is impossible to draw hard 
and fast lines, and the aim of this section of the book is 
to prevent people, so far as is possible by mere writing, 
from losing money through the purchase of securities 
which they are not qualified to judge. The aim of the 
book is, in short, educational, and those who do not need 
any education in securities have no need either of this 
section, or of the book itself. 



SECTION II 
CLASSES OF SECURITIES 



VI 

United States Bonds 

EVEN though the general interest in United States 
bonds is so very limited, they are worth the 
attention even of the relatively small investor, 
because of their great merit as a cash equivalent. It was 
observed in the chapter on Managing Investments that 
the saving to be made through holding bonds of extra- 
ordinary stability during bear movements and panics is 
exceedingly large. The possession of a cash equivalent — 
that is equivalent in stability — is therefore at such times 
a prime necessity to all those who are free to handle 
their securities as they like, and who wish to obtain the 
highest possible yield consistent with absolute conserva- 
tism. 

For the small investor handling total funds of not 
more than a few hundred or a few thousand dollars, the 
natural cash equivalent is, of course, a savings bank 
account, or several of them if need be. Such accounts 
have the merit of drawing somewhat more interest than 
United States bonds, but they also have an important 
defect. This is that just when the wise investor wishes 
to purchase securities, in the very midst of a panic, funds 
deposited in a savings bank are likely to be unobtainable. 
In ordinary times these banks waive the right to require 
30 days' notice or more, as the law may specify, but in 

(53) 



54 Sound Investing 



panic times they are much less likely to waive this right. 
Furthermore, no savings bank is as safe as United States 
bonds. The great desirability of making purchases in 
panic times is that good stocks then yield one to two 
per cent, above normal, good bonds three-quarters to 
one and a half per cent., and strictly high-grade bonds 
a half to one per cent, above normal. 

United States bonds yield only about 2 per cent, less 
than the very best of all other bonds — namely, those of 
the individual States. In 1907, nevertheless, they depre- 
ciated 3 per cent, less, so that as a cash equivalent they 
have no equal. Considering both yield and stability, 
they are the best securities in the world to hold through 
a bear movement; and besides this, they have distinct 
advantages over a savings bank account. It is, therefore, 
very wise to invest in them, quite regardless of the low 
yield, whenever security prices become so high or gen- 
eral business so inflated as to presage a bear market. 

Every class of bonds has what might be called its 
"fluctuating principle, ,, by which is meant the principle, 
or economic factor, or business influence, in accordance 
with which the price moves up and down. The fluc- 
tuating principle of State bonds and the best municipals 
is the prevailing price of capital. When, for illustration, 
the actual average cost of new capital to municipalities 
and corporations rises from 4 to 5 per cent., there is a 
similar rise in the yield of these bonds, and a correspond- 
ing decline in their average prices. The fluctuating prin- 
ciple of a convertible is found in the movements of the 



United States Bonds 55 

stock into which it is convertible ; and that of a debenture 
is found in the earning power and financial strength of 
the issuing company. 

But United States bonds possess a fluctuating prin- 
ciple all their own. This is due to the fact that most 
of them are used by the national banks as security for 
bank note circulation. , The profits which the banks 
make upon this circulation increase when the interest 
rates for money rise, and decrease when rates fall. Thus 
it comes about that when interest rates are rising, 
United States bonds become more and more valuable to 
the banks, and vice versa. The fluctuating principle 
of these bonds, therefore, is the rise and fall of interest 
rates. This fact is clearly disclosed in the following 
parallel between the movement of interest rates and the 
movement of the prices of these bonds. 





Reg's. 2s 


of 1930 


Coups. 3s 


of 1918 


Interest 


Price of 


Year 


High 


Low 


High 


Low 


rates 


capital 


1900... 


... 107 


104 


112% 


108% 


4.33% 




1901... 


.. 109y 8 


105% 


112 


108% 


4.32 




1902... 


.. 109% 


108% 


110 


105% 


5.03 


4.08% 


1903... 


... 109% 


106 


110 


106% 


4.77 


3.30 


1904. . . 


.. 107% 


105 


108 


104% 


3.34 


3.93 


1905... 


.. 104% 


103% 


106 


102% 


4.25 


4.04 


1906... 


... 105% 


103% 


104% 


102% 


5.94 


4.33 


1907... 


.. 109 


104% 


106% 


100% 


6.16 


4.53 


1908... 


.. 104% 


103% 


102 


100% 


3.47 


4.15 


1909... 


... 102% 


100% 


102% 


100% 


3.52 


5.03 


1910... 


.. 101% 


100% 


103 


101% 


3.98 


5.00 


1911... 


.. 101% 


100% 


102% 


101% 


3.07 


4.89 


1912... 


... 101% 


100% 


103% 


101% 


4.06 


4.85 



The tendency here displayed for these bonds to rise 
and fall with interest rates is very distinct, and the 



56 Sound Investing 



rates given are the yearly averages for all money loaned 
in New York. The exhibit emphasizes the fact that the 
fluctuating principle is not the changes in the prevailing 
prices of capital. The price of capital, as here given, is 
the average yield shown by a large number of new bond 
issues floated in the United States each year respectively. 
From 1904 to 1907, for illustration, the price of capital 
was steadily going up, and yet United States bonds per- 
sistently advanced — whereas, the advance in the price 
of capital, had that been the fluctuating basis, would 
have carried them down. 

At times such as 1902 and 1906, when overproduction 
and overconsumption are the rule and the general infla- 
tion of business foreshadows a bear movement, interest 
rates are always high; and consequently the prices of 
these bonds are high. At the very time then, when the 
investor should buy them to hold as a cash equivalent 
during a slump in security prices, their yields are the 
lowest. Instead of yielding from 2.1 to 3 per cent., their 
return at such times is only from 1^ to 2^4 per cent. 
Furthermore, they are very difficult to obtain, because of 
the great demand for them as a basis for circulation or 
as security for United States deposits. Because of the 
substitution of federal reserve notes for the old bank 
notes, however, they will probably be easier to obtain at 
the top of the next bull market than they were in 1902 
and 1906, and should also yield a little more. In spite 
of their low yield their stability makes them desirable 
as a cash equivalent at such times. 



United States Bonds 57 

The distribution and uses of United States bonds at 
a date when both mercantile and financial conditions 
were approximately normal, namely October 31, 1912, 
were as follows : 

Bonded Securing Securing Held as 

Bond Debt Circulation Deposits Investments 

2s of 1930 $646,250,150 $601,762,600 $12,516,700 $ 49,970,850 

3s of 1908-1918.. 63,945,460 20,419,220 3,681,300 39,844,940 

4s of 1925 118,489,900 26,817,000 3,741,000 87,931,900 

Pan. Can. 2s 1906 54,631,980 52,684,280 1,468,500 479,200 

Pan. Can. 2s 1908 30,000,000 28,574,180 657,000 768,820 

Pan. Can. 3s 1911 50,000,000 16,888,000 33,112,000 

Totals $964,631,630 $730,257,280 $47,057,500 $212,107,710 

The great bulk of United States bonds are held by 
national banks, but considerable amounts are also held 
by other banks and investors. These other banks and 
investors have confined themselves principally to the pur- 
chase of the 3s and 4s, which show a larger yield. The 
above totals, which include not only the six items enu- 
merated, but also some other smaller items, disclose the 
rather surprising fact that in October, 1912, when we 
were just in the beginning of a substantial bear move- 
ment in stocks and bonds, investors held as pure in- 
vestments 212 million out of a grand total of 964 million 
United States bonds. Their usefulness was thus appre- 
ciated by a small but very shrewd portion of the invest- 
ing public. Since then railroad stock prices have fallen 
from 120 to 87y$, and bond prices from 89.34 to 80.67. 

While the Federal Reserve Act, then known as the 
Glass bill, was up in Congress, there was great danger 



58 Sound Investing 



for a time that the circulation privilege would be taken 
away from the 2s of 1930, and no compensating advan- 
tage given. Had this been done it is probable that the 
investment value of these 2s, which constitute the bulk of 
all United States bonds, would have been lowered to 90 
or 85. Before the bill became a law, however, it was 
so amended as to preserve the niarket for these bonds. 
It was provided that an amount equal to 5 per cent, of 
all the U. S. bonds deposited with the treasury as security 
for circulation might be retired each year. In exchange 
for them the holders are to receive one-half in one-year 
3 per cent, gold notes of the United States, and one- 
half in 30-year 3 per cent, gold bonds — both without 
the circulation privilege. 

It is evident that the Federal Reserve Act did not 
seriously injure the position of the 2s. In January, 1912, 
when money was easy and bond prices generally were 
fairly high, these 2s were selling at 100^4 \ and in Jan- 
uary, 1915, when money was easy but bond prices were 
generally low, they were selling around 99. Good mort- 
gage railroad bonds on the latter date, not including the 
very best gilt-edged underlying issues, were selling about 
nine points lower than on the earlier date. The yield of 
the 2s had meantime risen only from 1.99 to 2.08 per 
cent. 

A great many people have mistakenly supposed that 
the credit of the United States is a very great deal higher 
than that of European governments, and was so even 
before the war began. This was a natural inference 



United States Bonds 59 

from the yields shown by various government bonds. In 
1911, for example, our 2s of 1930 sold on 1.95 basis 
and the 4s of 1925 on a 2.69 basis, whereas the Ger- 
man 3s yielded 3.59 and the German 4s 3.92. French 
rentes were selling on a 3.14 basis, and British consols 
on a 3.15 basis. 

The error of supposing that these figures represent 
the relative credits or standings of the various govern- 
ments arises from failing to make due allowance for 
the value of the circulation privilege carried by United 
States bonds. According to an estimate of the Comp- 
troller of Currency, the value of this privilege varied 
from 1.305 to 1.397 per cent. This is the net profit made 
by the national banks through the ownership of these 
bonds by means of issuing notes against the bonds. On 
the 4s of 1925 the profit varied from 1.124 to 1.301 per 
cent., varying according to the different prices at which 
the bonds were purchased. On the Panama Canal bonds 
maturing in 1936, the estimated profit varied from 1.322 
to 1.438 per cent. 

As a matter of fact, including the value of the circula- 
tion privilege, United States bonds have generally sold 
around a 3.65 basis. This is surely logical in view of 
the fact that interest rates in normal times average about 
1 per cent, higher in New York than in London and 
Paris. The United States government is able to borrow 
money cheaply, simply because it has thrown the burden 
on the banks by virtually compelling them to own United 
States bonds. 



VII 

Other Government Bonds 

ASIDE from United States securities the best bonds 
available to investors in this country, are, as a 
class, those of the various states. All the states 
in the Union in 1913 had aggregate indebtedness of only 
$345,942,305, whereas the municipalities and minor civil 
divisions showed total debts of $3,475,954,353. Because 
of this small indebtedness the credit of our states is 
very high, and for the same reason their bonds are much 
safer investments than the great majority of foreign 
government securities. 

Discrimination should, however, be made amongst the 
several states. In general, those which are the most 
conservative politically have the highest credit, pro- 
vided only the greater "conservatism" does not also 
mean more extensive political corruption and dishonesty 
— as it sometimes does. Those states in which extreme 
democratic, communistic or socialistic ideas generally 
prevail do not have, and are not entitled to, very high 
credit. The bonds of any state depend for their re- 
demption on the legislature, and where the political 
complexion is very radical there is greater danger either 
of actual repudiation, or else of enactments which will 
directly or indirectly diminish the investment value of a 
bond. 

(61) 



62 Sound Investing 



Furthermore, the investor, if he be careful, will be- 
fore buying a state bond write to its treasurer, or comp- 
troller, or auditor, and obtain one or two of the official 
reports showing the condition of the state finances. 
The points which such reports should disclose are the 
following : 

(1) A condensed income and expense account, 
stating the cash on hand at the beginning of the year, 
the receipts, the expenses and cash at the end of the 
year. 

(2) A detailed income account subdividing the re- 
ceipts according to sources of revenue, and including 
a statement of the assessed valuation of various kinds 
of property with the rates of taxation upon each. 

(3) A recapitulation of income covering a series of 
years, and subdivided by sources so as to show the 
variations in the burden and distribution of taxation. 

(4) A detailed expense account subdivided accord- 
ing to purposes of expenditure, and distinguishing 
clearly between outlays for current expenses and out- 
lays for additional property or assets. 

(5) A recapitulation of expense covering a series 
of years, and itemized according to the things or services 
purchased, so as to show the change from year to year 
in the efficiency of administration. 

(6) A detailed statement of assets showing the 



Other Government Bonds 63 

principal items such as land, buildings, public utilities, 
if any, securities held, and bank deposits. 

(7) A detailed account of liabilities such as perma- 
nent and temporary debts, bills payable, unmatured 
interest, dues on contracts, and unpaid claims. This 
should include a debt statement showing the various 
maturities, and the purposes for which the debts were 
contracted. 

(8) It should give a condensed balance sheet setting 
off against each other the principal items of assets and 
liabilities, and showing the net actual excess of the 
one over the other. 

There is probably not a state in the Union that makes 
a clear and businesslike report such as this; but the 
more of these items contained, the more confidence 
the investor may have in the integrity and credit of the 
given state government. Some of the absolutely essen- 
tial items are a debt statement and detailed accounts 
of income and expenses. As a general rule state bonds 
sell very close to their real values, reflecting pretty 
accurately the deserved standing of the state. Their 
yields vary from 3% to 4$£ per cent., and average about 
4.26 per cent. 

In the purchase of the bonds of foreign governments 
the risk is very much greater than in buying those of 
our states. This is true even of the Canadian prov- 
inces; but the general reason for it is that it is rather 
difficult for the ordinary investor to discover the real 



64 Sound Investing 



condition of the finances of the foreign government. 
To judge of the value of its bond he should first learn 
its total indebtedness, and then divide that by its popu- 
lation to find its debt per capita. Where the per capita 
debt is high the credit of the given government should 
not be considered good unless the per capita wealth 
is also high. Data upon the latter point are rather 
difficult to obtain, and this is one of the obstacles to 
conservative investing in foreign government securities. 

Indeed any thorough knowledge of debts is difficult 
to obtain, because in order to get at the real situation 
the investor must learn not only the amount of the debt 
of the central government, but also that of minor civil 
divisions such as cities, provinces, counties and the like. 
As between the central government and the minor civil 
divisions every nation apportions the powers, duties and 
liabilities differently, so that before one can intelligently 
understand the real position of a foreign government 
bond he must possess a broad and detailed knowledge 
of the government and its people. 

Having learned the per capita debt the next thing is 
to find out the per capita wealth and income. In the 
United States it would take only about 18 per cent, of 
the aggregate yearly income of the whole people to pay 
off the entire indebtedness of all governments from that 
of the United States down to those of the smallest 
towns; and in Canada it would take about 27 per cent. 
Where these aggregate debts amount to more than 30 
per cent, of one year's income for the whole nation, the 



Other Government Bonds 65 

bond to be attractive should yield 5 or 6 per cent, or 
even more. 

In determining these important points the investor 
should study such matters as productive industries, 
foreign commerce, railroads, volume of money and the 
like. Some of the authorities to be consulted are: The 
Statesman's Year Book, Whitaker's Almanack, the 
Statistical Abstract of the United States, the Statistical 
Abstract of Foreign Countries (published in London), 
the appendix to the Monthly Summaries of Commerce 
and Finance (published in Washington), MulhalFs Dic- 
tionary of Statistics and other works, and the latest 
encyclopedias. Those who trust wholly to the bond 
circulars and do not look up these points for them- 
selves are apt to regret it; for it is the business of bond 
houses, after a reasonable investigation to make sure 
that the bond will be redeemed, to sell securities. It 
is not their business to inform the investor of the weak 
points in the financial condition of foreign governments, 
and they do not do it. Their descriptions are largely 
confined to the strong points. 

Estimating the per capita income of any nation is a 
difficult procedure, but even without such an estimate, 
by a careful study of the above authorities one can 
obtain a fairly good notion as to the credit of a foreign 
government. Recently the per capita income of the 
people of the United States was estimated at about 
$260, including men, women and children, and 
that of Russia at $50. In their order from the 



66 



Sound Investing 



top down the earnings of various nations were ranked 
as follows: 



1. United States 

2. Australia 

3. United Kingdom 

4. Holland 

5. Germany 

6. Dominion of Canada 

7. France 

8. Denmark 

9. Belgium 



10. Norway and Sweden 

11. Switzerland 

12. Argentina 

13. Austria-Hungary 

14. Portugal 

15. Spain 

16. Japan 

17. Italy 

18. Russia 



These estimates, even though not absolutely reliable, 
should prove useful. 



VIII 

Municipal Bonds 

SINCE 1900 municipal bonds have assumed a degree 
of importance which was not dreamed of a gen- 
eration ago. This lies not only in the total amount 
of the issues, but also in the large bank holdings of mu- 
nicipals, and in their popularity with investors. This pop- 
ularity is based in part upon the very high average qual- 
ity of the bonds themselves, but also in part upon the 
fact that they are free from the Federal Income tax and 
also from State taxation. They constitute practically 
one-third of the security holdings of all banks in the 
United States, and the amount issued averages about 
$350,000,000 per annum. 

These bonds are, moreover, among the most stable 
of all the securities from which the investor may 
choose; and the principal difficulty he encounters in 
making his selection arises from lack of generally ac- 
cessible information regarding municipalities. Broadly 
speaking, the inquiries which he must make divide them- 
selves into four groups: First, the industrial character 
of the municipality must be determined; second, its 
financial condition must be studied; third, its political 
character must be scrutinized; and fourth, the technical 
features of its bond issues must be learned. 

Technical information is, of course, readily obtainable 

67 



68 Sound Investing 



from any good bond house; and from this source one 
can cover such points as the borrowing power of the 
given municipality, its debt limitations, and the question 
as to what extent its securities are exempt from taxa- 
tion. 

Political character is a more difficult subject to study; 
for upon this point accurate information is not obtain- 
able, and it is necessary to lay aside one's prejudices as 
to party lines, and candidly inquire to what extent the 
city's credit is affected by the management of politicians. 
As there is no city which is entirely free from graft, 
and surely none which is free from serious charges of 
graft, made for political purposes, probably the best way 
to approach the subject is through an examination of 
municipal expenditures and their purposes. This can 
best be made by securing from the United States De- 
partment of Commerce and Labor a copy of the Bulletin 
entitled "Statistics of Cities" which is published yearly. 

Since this bulletin shows the per capita expenditures 
of all leading cities for police and fire protection, health 
and sanitation, highways, charities and corrections, edu- 
cation, lighting systems, water supply, and other public 
purposes, it is not difficult to form a reasonably correct 
opinion as to whether the finances of the city in question 
are, or are not, managed for purposes of graft. Com- 
parisons are made easy because all the figures are here 
given not only in gross amounts, but also upon a per 
capita basis. 

The financial condition of the given municipality 



Municipal Bonds 69 



should be judged principally from the rate of increase 
in its net debt, the percentage of yearly revenue to net 
debt, and the sinking fund provisions. Of these con- 
siderations the rate of growth in debt is by far the most 
important The aggregate indebtedness of all cities in 
the United States increased from $1,279,735,500 in 1902 
to $2,833,216,000 in 1912. The rate of increase since 
1906 has been rapid, and the ratio of annual municipal 
revenue to indebtedness has fallen from 37.24 cents on 
the dollar in 1902 to about 30 cents at the present time. 
Therefore, other things being equal, the bond of a muni- 
cipality whose indebtedness is increasing at less than 
this average yearly rate is the more desirable. 

It is especially desirable that indebtedness should not 
grow more rapidly than revenue — except of course in 
the case of cities which are growing very fast in popu- 
lation, and are therefore in a similar position to that 
of an industrial company which is just erecting its 
plants, and is charging the cost of the same to capital 
account, with the full knowledge that about all to be 
required thereafter will be moderate yearly charges for 
maintenance and depreciation. Whether a city is, or is 
not, in this position should be determined by comparing 
its per cent, of increase in wealth and population with 
the average rates of increase; and these figures may be 
obtained from the Census Bulletins already referred to. 

Other considerations bearing upon the subject of 
financial standing, are the relation of tax rates to true 
valuation of property and of the ruling rate of interest 



70 Sound Investing 



in the given locality to the rate of income on the city's 
bonds. A municipality which sells its bonds at so low 
a price as to yield the investor an income materially in 
excess of the ruling local rate of interest on time money 
— taking the average rate of four or five years rather 
than of any one time — thereby concedes that its own 
credit is poor, unless there is some special explanation. 
Moreover, the bond of a city whose tax rate is high, 
as compared with the true valuation of its property, is 
somewhat the less desirable on this account, unless the 
rate of increase in per capita wealth is exceptionally 
high. 

Industrial conditions, however, are by far the most 
important in judging the intrinsic values of municipal 
securities; and these can hardly be studied to advantage 
without first obtaining from the United States Census 
Bureau a comparative summary of manufactures by 
municipalities. These summaries show the growth in 
the manufacturing industries of all our cities of any 
consequence; and manufacturing forms a very im- 
portant part of the total business of any city possessing 
any high degree of stability. If population is drifting 
away from a city because of the decay of its leading 
industry, or because the city has been sidetracked by the 
main channels of commerce, or for any other reason, 
this fact is pretty certain to be reflected either in a 
decline, or else in a slow rate of growth in its manu- 
facturing business. 

For example, an Ohio city, years ago, with a popula- 



Municipal Bonds 71 



tion of 125,000 and a net debt of $21.68 per capita, was 
selling its bonds on a 3.65 basis; while a Pennsylvania 
city having the same population, but having a debt of 
only $7.68 per capita, was obliged to sell on a 3.90 basis. 
One would naturally expect the Pennsylvania city to 
obtain its money the cheaper, not only because of its 
smaller debt, but also because eastern cities, generally 
speaking, are able to borrow at lower rates than western. 
But upon inspection it is observed that from 1900 to 
1905, the Ohio city's output of manufactured products 
increased from $31,015,293 to $39,596,773, whereas at 
the same time the Pennsylvania city's output decreased 
from $24,741,837 to $20,453,285. 

Actual industrial growth is the most convincing proof 
of the value of a city's bond; but on account of their 
bearing upon future growth, the character of a city's 
industries, the stability of its population, and the ques- 
tion of its per capita wealth should be observed. De- 
pendence upon a single industry is ordinarily unde- 
sirable, unless that industry is based upon some physical 
characteristic of the place, such for example, as the 
presence of great and inexhaustible coal mines, which 
renders the industry permanent. Stability of popula- 
tion is increased by diversity of industries; and a muni- 
cipality which is a natural thoroughfare of commerce 
has a distinct advantage. 

In interpreting these principles it is necessary to set 
up certain standards by which to judge. The question 
is constantly before us whether a certain amount of in- 



72 Sound Investing 



debtedness is large or small, and whether a tax rate is 
high or low. These standards may be obtained from 
the aggregates for all cities in the United States. In 
1912, the latest year for which complete reports are 
available, the assessed valuation of all city property was 
$30,703,170,062, and its true valuation was probably 
about $36,084,589,000. Outside of New York City 
municipal property is assessed at an average rate of 
about 75 per cent, of its true value, and this forms the 
basis of the estimate just given. 

Therefore it appears that the aggregate municipal in- 
debtedness of $2,833,216,000 as of 1912 was equivalent 
to 7.85 per cent, of the estimated wealth. This being 
true, we may regard the debt as being small or large 
according as it is below or above 7.85 per cent. Outside 
of New York, the debts per capita averaged $68.24, and 
this may be regarded as the standard. To include New 
York City in the average would lead to erroneous con- 
clusions, not only because the wealth of New York is 
so vast as to inflate the per capita average, but also 
because its indebtedness is excessive and unrepresenta- 
tive. 

As to tax rates, the actual average for 1912 was 
$18.34 on the assessed valuation of property, while the 
average on the true valuation of the same was about 
$15.00 per thousand. 

In examining bond circulars with a view to investing, 
careful observance must be made of the form in which 
the statements are given. During the past two or three 



Municipal Bonds 73 



years an evil practice has grown up of stating the net 
indebtedness of a city as if it were the total debt, minus 
not only the sinking fund but also the water debt. Mani- 
festly a water debt is, in the strictest sense of the words, 
a portion of the net debt, and to deduct it in this way 
is a mild form of misrepresentation, since it makes the 
so-called net debt appear less than it really is to the 
unobserving. The only deduction to be made in ob- 
taining the net debt from the gross is the sinking fund. 

Circulars which indulge in this practice should be 
further examined, especially for errors in population. 
As the Census is taken only once in ten years, population 
is estimated, and the per capita debt obtained by divid- 
ing the total by this estimate. It frequently happens 
that the estimates are much too high, thus making the 
per capita debt appear correspondingly too low. Recent 
and reliable estimates of population can usually be ob- 
tained from the Census Bureau at Washington. 

Subject to these qualifications much of the detail of 
examining a municipal bond may be left to the bond 
house through which the purchase is made; and subject 
to the following principles the investor may often be 
contented to choose the bonds showing the higher yields. 
First, he must assure himself that the bond is legally 
issued, and is exempt from taxation. Second, the total 
per capita expenditures of the given municipality must not 
be so great as to indicate unusual extravagance. Third, 
the rate of increase in net debt should not exceed the 
average, and the percentage of yearly revenue to in- 



74 Sound Investing 



debtedness should not decline unless there is some spe- 
cial justification. Fourth and most important, the city 
must show growth, as indicated by its population and 
its output of manufactured goods. 



IX 

Railroad Mortgage Bonds 

RAILROAD mortgage bonds are very high grade 
securities, ranking but little, if any, below mu- 
nicipals. Indeed, until municipals were given 
the advantage of exemption from the Federal income 
tax, their superiority over railroad mortgage bonds was 
rapidly disappearing. It might not have been too much 
to say that first-class bonds of this type were actually as 
high grade as municipals. Because of this quality these 
bonds should invariably be bought for their safety of 
principal rather than with the idea of obtaining any high 
yield, or any material profit through appreciation in price. 
In examining such bonds the first point to look at is 
the amount outstanding per mile of line. This throws 
much light upon the value of the given bond, because 
the typical mile of railroad line in the United States 
is intrinsically worth between $50,000 and $60,000. 
However, there are many single track lines which are 
not worth more than $25,000 per mile, and some which 
are not worth more than $10,000. On the other hand, 
there are double track lines built with 100 or 125 pound 
rails which are worth as high as $125,000 per mile. 
Therefore the investor must look further. 

In doing so a good map of the road is indispensable, 
since it is necessary not only to learn whether the mile- 

(75) 



76 Sound Investing 



age covered is main or branch lines, but also where it is 
located. If it is a mere spur reaching to some unim- 
portant town or district, it may not be of much value. 
Furthermore, if this spur or short branch line happens 
to be held under a terminable lease, or by stock control, 
it might be lopped off any time. The lease could be 
terminated, or the stock qqllateral could be sold. 

Thus it is very important, even after knowing the 
location of the mileage, to know also the earning power 
of that particular mileage. This is difficult to get at, 
since gross and net earnings are not subdivided by 
branches, or by mortgages ; but one can obtain some idea 
by finding from any good Atlas the names of other 
roads operating in the same locality, and then by learn- 
ing from the financial manuals the per mile earnings of 
these other roads. 

Another good method is to visit some large library, 
and learn if possible from the old financial manuals how 
much this particular branch line earned before it was 
absorbed by the parent company. If even then the 
investor is doubtful, he has still another resource. Quite 
a number of states have made valuations, or other exact 
records, regarding the railroads within their borders, 
and by writing to the Secretary of the State in which 
the line is located, one may often obtain much valuable 
information as to the traffic, road bed, the kind of bal- 
lasting used, the weight of the rails, etc. 

Accepting as final the opinions of one's bond house 
regarding these details is an error, because the very 



Railroad Mortgage Bonds 77 

purpose of making a personal examination is to guard, 
not against dishonesty, but against the mistakes of the 
bond houses. If the bond house did not believe in the 
bonds, it would not risk its reputation by floating them; 
but even the best houses can, and do, occasionally make 
mistakes. Furthermore, there has grown up a practice, 
due probably more to the issuing corporation than to 
the bond house, of misusing the high credit of strong 
railroad corporations in the flotation of new issues. 
The misuse referred to consists in floating a second 
mortgage or other junior bond at the price of a first 
mortgage. 

The credit of some railroads, because of their large 
earnings, is so high that even a second mortgage may 
be floated around a 4J4 per cent, basis. This, however, 
is not fair to the investor, because there may later on 
be issued enough junior obligations to absorb the bulk 
of the surplus earnings remaining after the payment of 
existing fixed charges. When this happens such a 
second mortgage bond is bound to sell strictly upon the 
merits of the security behind it, and to fall 5 to 15 
points below the high flotation price. 

Whether the given mortgage is open or closed is also 
an important matter. For example, the Atlanta and 
Charlotte Air Line Railway Company, which is a leased 
line of the Southern Railway, sold in 1915 $3,500,000 
first mortgage bonds, Series B, due July 1, 1944. In 
June, 1914, $5,500,000 of these were sold, so that 
$9,000,000 are outstanding, and the authorized issue is 



Sound Investing 



$20,000,000. The mortgage covers 263 miles, so that 
the amount per mile is $34,200. If this were all that 
would ever be issued, the bond would be high grade, 
but as the mortgage is open the balance may be issued, 
raising the debt per mile to $76,000, which is probably 
at least $25,000 in excess of the value of the mileage. 

Because of the uncertainty as to how long the margin 
of safety, or the excess of net income over charges, will 
remain wide enough to render this bond high grade, the 
investor needs to watch the income accounts from year 
to year. Herein lies another weak point in the bond, 
since it is impracticable to do this. Being a subsidiary 
leased line, with practically no individuality of its own, 
the manuals contain no separate income account, and it 
would be almost impossible to learn from year to year 
how the course of earnings may affect the value of this 
bond. Furthermore the parent company makes heavy 
charges against this subsidiary for hire of equipment. 
These are included under the heading "other deduc- 
tions ;" and in 1914, although gross earnings increased 
only $16,630, these "other deductions" increased by 
$104,693. There is then no certainty at all that these 
bonds will be able to maintain their original market 
value. 

Many of the bonds issued nowadays represent mixed 
mortgages, being secured partly by first mortgages, and 
partly by second or third, and sometimes partly also by 
various collateral. In such a case the difficulty of estimat- 
ing the worth of the bond is great. The method to be fol- 



Railroad Mortgage Bonds 79 

lowed is to first estimate upon the mileage basis the total 
value of all the property covered by all the mortgages 
under the bond. Then look up all the prior liens and de- 
duct their amount from the gross valuation. In this way 
the amount of property behind a given bond can be esti- 
mated. Collateral security, unless it consists of stocks 
and bonds for which genuine quotations can be found, 
should be largely ignored, as a great deal of collateral 
held in corporation treasuries has merely nominal 
values. 

Another question to be examined is whether the given 
mortgage is a direct mortgage on the physical property 
itself, or merely a mortgage on the stocks which own 
the physical property. A direct mortgage is, of course, 
quite superior to a collateral mortgage. Besides this, it 
is important to know whether the bond is a direct obli- 
gation of the parent company, or an obligation of one 
of its subsidiaries. Obligations of subsidiary companies 
are greatly inferior unless these subsidiaries make sep- 
arate annual statements of earnings, assets and liabilities. 
Still further, one should learn if possible whether the 
mortgage covers merely the road bed, or covers also 
various terminal properties and the equity in equipment. 

Guarantee should not be valued too highly as an ele- 
ment of value. A great many subsidiary bonds are 
guaranteed as to interest, or as to principal, or as to 
both. However, the strength of such guarantees de- 
pends upon the indenture, and this strength is in itself 
a complicated legal question which the investor cannot 



80 Sound Investing 



pass upon. Hence, such guarantees, unless made abso- 
lute by endorsement, should be generally distrusted to 
the extent that the investor should be unwilling to pay 
more than a few points more for a guaranteed bond 
than he would pay for the same bond if it were not 
guaranteed. There have been quite a number of in- 
stances in which supposedly iron-clad guarantees have 
proven practically worthless because of some legal tech- 
nicality, or of some unobserved clause in the indenture. 

Divisional liens are also to be examined with scru- 
pulous care before purchasing. For illustration, the 
Central Branch 4s due 1919, were supposed until some 
time in 1914 to be a high-grade mortgage bond. They 
were a mortgage upon the former Central Branch Rail- 
road, which is now a division of the Missouri Pacific 
Railway Company. Under the reorganization plan of 
1915 the holders of these 4s were offered 50 per cent, in 
new general mortgage 4s and 50 per cent, in either the 
new 5 per cent, preferred stock, or else the new 5 per 
cent, income bonds. It thus appears that the Missouri 
Pacific Railway Company did not after all absolutely 
assume the liability for these 4s in an unqualified way. 
Hence, instead of being a strictly high-grade first mort- 
gage bond, they were the equivalent of a debenture, and 
far from being worth 95 to 98, they were worth only 
75 to 80. 

To the investor who desires to avoid such issues, the 
only answer is that there is no sure method except to 
discontinue the purchase of divisional mortgage bonds. 



Railroad Mortgage Bonds 81 

In the case of a bond which is a mortgage not on the 
entire road, or on an entire subsidiary operating com- 
pany, it is impossible to obtain a separate income ac- 
count or balance sheet. No road makes a separate state- 
ment of the assets or earnings of each of its divisions. 
Hence it is impossible to find out what the division is 
worth per mile, or whether the bond is really secure or 
not. At least it is impossible for the average man 
because he has not the time either to go over the divi- 
sion, or to employ engineers to do so. Neither is it 
practicable for the ordinary investor to obtain a com- 
plete copy of the indenture of the bond, or to find out 
what it means if he has it. To do so would involve very 
heavy legal fees. 

At best the buyer of a divisional lien takes a chance. 
In taking this chance two of the best practical safe- 
guards are, first, to subdivide the investment so as not 
to lose heavily on any one bond; and second, to recog- 
nize the ever-present uncertainty as to whether a divi- 
sional lien is the more like a first mortgage bond fully 
secured by assets, or the more like a debenture resting 
merely upon the credit of the road. In the case of small 
divisional liens especially, it is a safe practice to sell out 
whenever net income fails to exceed total charges by 
more than 25 per cent. 

Notwithstanding the many possibilities of loss which 
have been pointed out, first mortgage railroad bonds 
are, as a class, very reliable. It is because of their high 
reputation that the temptation is so great to represent a 



82 Sound Investing 



railroad bond as a first mortgage issue, even when there 
is some serious defect in it. However, if one is going 
to invest money blindly, and without examination, he 
will lose less in first mortgage railroad issues than in 
any other class of bonds except government and mu- 
nicipal bonds. 



Gas and Electric Light Bonds 

PUBLIC utility securities have recently enjoyed a 
considerable boom. First, in the early history of 
this country, we had our boom in bank stocks, 
and it was generally thought that all one had to do to 
get rich was to buy such stocks. Next came the boom 
in canal stocks; and after investors had lost a few 
hundred thousand dollars in learning the lesson that the 
canal business was not all profit, they applied this same 
fallacy to railroads. For many years up to 1873 it was 
widely believed that railroad maintenance expenses 
amounted to practically nothing, and that the surest 
way to get rich was to buy railroad shares. Then along 
came the street railways; and their promoters spent so 
little on way, structures and equipment that all three 
were soon worn out. Besides that they made insufficient 
allowances for operating expenses, interest and depreci- 
ation, and capitalized the new concerns on the theory 
that there wasn't really much difference between gross 
earnings and net income. The street railways have 
been ten years recovering from this error, and they 
haven't fully recovered yet. 

Next came the other public utilities, and the same 
error which has been repeated by other generations of 
investors is re-enacted in these securities. Experience 

(83) 



84 Sound Investing 



is the great teacher, but the lessons are never inherited, 
each generation having to learn its own. This is why 
so many investors have since 1912 been caught in the 
securities of the American Water Works and Guaran- 
tee Company, and in other similar securities. Every 
boom has its reaction, and the boom in public utility 
flotations can hardly prove an exception. However, all 
that the investor needs, to avoid such losses, is exercise 
of discretion. 

Of all the classes of securities included under the 
general name "public utilities, ,, gas company bonds are 
probably the most seasoned and stable. Seasoning does 
not necessarily require age, and we have scores of new 
railroad bonds which are just as well "seasoned" as 
some of those which are twenty or thrity years old. 
Seasoning is a question of standards, and the railroad 
business has been thoroughly standardized. We have 
had so much experience that we know how much it will 
take to build the roadway and terminals; how much 
gross per mile the new road running through a given 
country with a given density of population will earn; 
how much of this can be saved for net and surplus; 
how much must be allowed for interest and deprecia- 
tion ; and at what figure the whole project can be safely 
capitalized. 

With a lot of public utility concerns we have not had 
enough experience to know such essentials as these; 
and without knowing them the stocks are very apt to 
prove worthless, and the bonds of doubtful value. 



Gas and Electric Light Bonds 85 

With gas bonds, however, we have had great experi- 
ence, and the standards are pretty well developed, so 
that managers and promoters know just about what it 
is practicable to accomplish in any locality. These 
standards were fairly well disclosed by the compilation 
given in Poor's Industrial Manual of 1910 regarding 
light, water and power companies; for with gas com- 
panies, which are included under this heading, the prin- 
ciples and relations are about the same. 

Capital stocks $2,108,233,079 

Funded debts 1,392,653,050 

Total capitalization $3,500,886,129 

Gross earnings 285,486,342 

Operating expenses 157,601,329 

Net earnings $ 127,885,013 

Interest paid 36,135,538 

Surplus $ 91,749,475 

Dividends reported 45,047,938 

Other deductions 14,343,871 

Final surplus $ 32,357,666 

The earnings account applies only to companies mak- 
ing complete returns; and the capitalization of these 
amounted to $1,869,339,018, of which $1,128,860,168 
consisted of stocks and $740,478,850 of bonds. The 
average rate of interest paid for all companies was 4.97 
per cent., and the average dividends 3.03 per cent. For 
the companies making complete returns the percentage 
of gross to capitalization was 15.27; net to capitalization 
6.84; expenses to gross 55.20; interest to bonded debt 



86 Sound Investing 



4.88; and dividends to capital stock 3.99 per cent. Ad- 
ditional comprehensive information, this exclusively 
about gas companies, was given in the Census Bulletin 
of 1910. From it the following showing was obtained: 

Items 1909 1904 %Gain 

Capital invested $915,537,000 $725,035,000 26 

Cost of materials 52,428,000 37,180,000 41 

Salaries and wages 33,316,000 25,522,000 31 

Other expenses 27,757,000 29,557,000 

Total expenses 113,501,000 92,259,000 23 

Value of products 166,814,000 125,145,000 33 

Net earnings 53,313,000 32,886,000 62 

Per cent, on capital 5.82% 4.54% 

Gas— cubic feet 150,835,793 112,549,979 34 

Value per foot $1,106 $1,112 

The average price of gas did not increase, and the 
total output expanded only 34 per cent., whereas the 
urban population of the United States during this time 
increased 39 per cent. There was, therefore, no over- 
consumption; and this business, unlike many others, 
did not become inflated during those five years. More- 
over net earnings increased 62 per cent., although the 
gross output grew only 34 per cent., and the price of 
gas fell slightly. Efficiency of operation, therefore, im- 
proved. Still another significant point is that wages and 
salaries increased less than gross business, and only 
half as much as net earnings, whereas in the case of 
railways and many other corporations wages and sal- 
aries are growing more rapidly than either gross or net. 

Earnings presumably available for dividends aver- 
aged 5.82 per cent, in 1909, against 4.54 in 1904; and 
this contrasts sharply with the decline of net railroad 



Gas and Electric Light Bonds 87 

earnings from 5.19 per cent, in 1904 to 4.74 per cent, 
in 1909. Using the foregoing and other figures as a 
basis for general conclusions, it is found that as a rule 
lighting and power companies have an asset value equal 
to about 5.4 times their yearly gross earnings, or 12.1 
times their yearly net earnings. Their capital stocks 
upon the average are intrinsically worth about 15.0 
times their yearly surplus earnings. 

Two primary essentials which every investor should 
insist upon before buying a stock or bond are, first, an 
income account, and second, a balance sheet. In the 
case of a holding company, both of these should be con- 
solidated accounts, including all the subsidiaries. Some 
holding companies give a consolidated income account, 
and a so-called general balance sheet, but do not give a 
consolidated oalance sheet, and therein lies the difficulty. 
Some such companies have gone into receivership simply 
because the bills payable of the subsidiaries were accumu- 
lating, whereas the bills receivable were remaining at 
a standstill. These changes investors are not aware of, 
because of the absence of a consolidated balance sheet 
and of the fact that the financial condition of the sub- 
sidiaries is therefore unknown. 

It is not mere professional interest in the study of 
finance which compels one to urge that investors should 
not buy the securities of companies which do not issue 
satisfactory income accounts and balance sheets. On 
the contrary, to invest in such securities is likely to be 
gambling of the blind pool type. It is not even good 



88 Sound Investing 



speculation ; for in speculation one buys a chance, know- 
ing it is a chance, and does so in the hope that the 
wheel of Fortune will turn in his favor. In buying 
these securities, however, one may get something not as 
good as a chance, because in the first place he does not 
know what it really is; and in the second place the 
wheel of Fortune cannot turn in his favor, because even 
if such a bond or preferred stock happens to be a real 
security, instead of mere capitilized possibilities, its in- 
come is limited and there is no chance of large profit 
in it. 

With electric lighting companies there is very little 
for the investor to judge from, because a relatively 
small proportion of the total value of the typical com- 
pany lies in its physical properties. A large propor- 
tion lies in the franchises which confer a sort of a legal 
monopoly, and in the earning power derived from this 
partial monopoly. Even the earnings are often ambigu- 
ously stated in the annual reports, because of the fear 
that to disclose a large income would lead to municipal 
interference. Hence the investor in analyzing the bond 
of an electric lighting or gas company has to meet con- 
siderable difficulties. 

In meeting these probably the best standards by 
which to judge are to be obtained from the census re- 
port of 1912, and from a compilation of light, water 
and power company statistics found in Poor's Industrial 
Manual of 1910. The value of the census figures is 
greatly diminished by the inclusion of a lot of insignifi- 



Gas and Electric Light Bonds 89 

cant companies whose capital stocks are practically 
worthless; but by checking up the two sets of figures 
against each other, we may obtain some valuable con- 
clusions and learn how to test the true worth of a light 
and power bond. Some of the more significant figures 
based in part upon Poor's compilation regarding elec- 
tric light and power companies are the following: 

Bonded debt at par $740,478,850 

Preferred stocks at market value 138,172,480 

Common stocks at market value 669,301,220 

Gross operating earnings 285,486,342 

Net earnings 127,885,013 

The market values of the capital stocks are here partly 
estimated; and upon this basis the total intrinsic worth 
of these companies which made full reports for 1909 
was $1,547,952,550. This embraces the aggregate values 
contained in both bonds and stocks. Now, comparing 
these values with gross and net earnings, they are found 
to be equivalent to 5.42 times the gross earnings, or 
12.10 times the net earnings. The surplus earnings 
shown evidently contained a good deal of duplication, 
or else were figured by the individual companies in- 
cluded, without making proper allowances for depreci- 
ation. In any event, they were manifestly too large, and 
cannot be used as a basis for valuations. Meanwhile, 
some of the more important points to be learned partly 
from the Census compilation of 1912 were the following: 

Bonded debts at par $ 897,907,681 

Preferred stocks at market value 119,500,000 

Common stocks at market value 572,000,000 

Total intrinsic value 1,589,407,681 



90 Sound Investing 



Total gross income - $ 302,115,599 

Urban population of United States 29,230,579 

Horse-power installed, above companies. 7,528,648 

Output in kilowatt hours 11,502,693,006 

The maximum amour' of bonds which could be is- 
sued by these companies, would be less than the above 
estimate of total intrinsic value because the common 
stocks taken even at their market values, contain a good 
deal of water. A considerable portion of the market 
value of a common stock represents voting power, fran- 
chises, expected future earning-power and the like. It 
is perhaps a fair estimate that one-half of the market 
value of the common stocks should be deducted in esti- 
mating the maximum amount of bonds which could 
properly be issued in the event that all these companies 
were to finance themselves almost wholly with bonds. 
This, of course, is a mere hypothesis, but it is useful in 
learning to distinguish those individual companies which 
have bonded debts in excess of the total value of all 
their tangible assets. In brief, we arrive at the follow- 
ing conclusions: 

Ratio of tangible and intangible assets to gross 5.4 

Ratio of all said assets to net earnings 12.1 

Ratio of surplus earnings to true value of stocks 15.0 

Tangible assets per capita of population $ 44.60 

Tangible assets per 1,000 kilowatt^ hours — $113.30 

Tangible assets per horse-power installed $173.10 

In examining the value of a given bond, the first thing 
to do is to learn the approximate total value of the 
property. After this is done, one may readily deduct 
the prior obligations and learn how much is left for the 



Gas and Electric Light Bonds 91 

given bond issue. If gross, net and surplus earnings 
are clearly stated, it is an easy matter to form a very 
good estimate. One should take as a basis either the 
average earnings of a series of three to five years, or 
else the earnings of a very typical year. Then the pro- 
cess is this: 



Gross earnings times 5.4 equals Total Assets 

Net earnings times 12.1 equals Total Assets 

Surplus earnings times 15, plus bonded debt equals. Total Assets 



Average of these three equals Final Estimate 

In the third of these three estimates, the bonded debt 
should be figured not at par, but rather at the ruling 
prices of the individual bonds which make up the debt. 
It should be borne in mind that these total assets include 
intangible values, so that not all of them form a proper 
basis for the issue of mortgage bonds. Having reached 
this final estimate it is an easy matter to get at the posi- 
tion of a new bond. If, for example, a given company 
is found to have total assets, as above estimated, of 
$10,000,000; and if it has outstanding $5,000,000 of 
bonds which constitute prior obligations to the new 
issue, and if the new issue itself is $2,500,000 — then 
there are about $5,000,000 of assets, tangible and in- 
tangible, to secure this new issue. Hence the new 
issue should prove a very good debenture. 

But if this new issue is put out as a mortgage bond, 
the investor should regard it, upon these figures, as a 
sort of a hybrid half way between a mortgage and a 



92 Sound Investing 



debenture. That is to say, from 20 to 40 per cent, of 
lighting and power assets are intangible, and form no 
proper basis for a mortgage. It is only the physical 
assets, including plants, equipment, inventories, cash 
and the like, which are capable of becoming real se- 
curity for a mortgage bond. Supposing the intangible 
assets in this case to be 25 per cent, of the total, the 
mortgagable total assets would then be $7,500,000 and 
the new issue of $2,500,000 would be covered by assets 
only to the extent of its par value, whereas a good 
mortgage bond must have behind it 125 to 150 per cent, 
in the shape of tangible assets. Such a bond as this, 
then, instead of selling on about a 5 per cent, basis, as 
it would if it were a good first mortgage bond, should 
sell on a S J / 2 or 5}i per cent, basis. 

If, however, statistics of gross, net and surplus earn- 
ings are not available, estimates must be very vague. 
Tangible assets may then be regarded tentatively as the 
equivalent of $44.60 per capita of population served, or 
$113.30 per thousand kilowatt hours, or $173.10 per 
horsepower installed. The amount of error in these 
rough estimates depends upon the question whether the 
given company is typical or not. These are the averages 
for the United States, and are true for the typical com- 
pany only. However, any estimate at all is better than 
none at all ; and indeed if a company is bonded in excess 
of the total assets indicated by these rough tests, its 
bonds are not to be considered as good investments. 
This is true, for the reason that these are tests for ob- 



Gas and Electric Light Bonds 93 

taining the maximum valuation of all assets, both 
tangible and intangible. 

A much better rule than to trust to these vague and 
inaccurate tests — meaning those mentioned in the pre- 
vious paragraph only, is to let such bonds alone entirely. 
The bond of a company which does not give income ac- 
counts and balance sheets is no fit investment for any- 
one but insiders and speculators. So-called insiders in 
the company may properly invest in such issues, because 
they know the facts which the annual reports ought to 
show but do not; but for the general public there is no 
substantial difference between speculating and buying 
such a bond, except that speculating at least affords the 
possibility of a large return on the money risked, 
whereas such bonds do not. 



XI 

Equipment Trusts 

EQUIPMENT trust notes were once a makeshift, 
but they have come to be one of the most regular 
and approved types of securities, and their ad- 
vantages are still unappreciated. They had their origin 
back in the seventies in the embarrassed condition of the 
railroads, which followed the panic of 1873. Many of 
our roads then found themselves short of the necessary 
equipment to handle the traffic, and not in such financial 
condition as to enable them to buy outright. They 
therefore adopted the expedient of buying on what was 
practically an instalment plan, paying 10 to 25 per cent, 
in cash, and giving for the balance notes which matured 
serially over a period of years. 

In the beginning, therefore, the issue of "car trusts," 
as they were then called, was properly taken as indicating 
an impoverished condition. These notes for the balances 
due were disposed of by the equipment makers for what 
they would bring. They were a sort of an emergency 
paper, which often sold far below par. It was in this 
way that car trust obligations at their very origin fell 
into disrepute. 

These notes, however, were not really "car trusts" or 
"equipment trusts" at first, because they were unsecured. 
Later the practice developed of withholding from the 

(95) 



96 Sound Investing 



railroads the title to the equipment bought until fully 
paid for. Under this plan a trust was created to hold 
the title, a trustee appointed, and a trust agreement 
drawn up under which the trustee held the title until 
the serial payments were completed and the railroad be- 
came the full owner of the equipment. It is the present 
practice to transfer the equipment to the trustee, who in 
turn leases it to the railroad, until the latter acquires the 
title to it by completing the payments. 

These bonds and notes are one and the same thing, 
generally speaking; for whatever is the name by which 
they are called, the security to the investor is the mort- 
gage held by the trustee upon the equipment. A rail- 
road cannot do business without engines and cars, and 
as it does not own these until the payments are com- 
pleted, the trustee, theoretically at least, can take them 
and sell them to another road if payments are not con- 
tinued. Hence it is that the security of a regularly 
drawn equipment trust bond or note is unlike all the 
other obligations of the railroads in that this security 
is largely independent of the financial condition of the 
road using the equipment. 

In its regular form such an obligation runs for ten 
years, and is extinguished by twenty semi-annual pay- 
ments. The amount paid down by the railroad, when 
it leases the equipment from the trustee, is 10 per cent, 
or more. The average actual life of the bond or note, 
therefore, is about five years instead of ten. However, 
until the payments are completed, the mortgage held by 



Equipment Trusts 97 

the trustee for the bondholders covers the entire amount 
of equipment originally bought, so that it is a peculiarity 
of these bonds or notes that the longer they have run 
the more secure they are. Theoretically, these twenty 
semi-annual payments merely cover the depreciation of 
the equipment; and according to this theory, the latter 
has no commercial value at all at the end of ten years. 
But in fact the payments much more than cover the 
depreciation, and the life of the equipment is a great 
deal longer than ten years. 

There are no accurate and comprehensive statistics of 
the life of equipment. However, during the past eleven 
years the average number of freight cars scrapped each 
year was equal to about 3.717 per cent, of the total num- 
ber in service. The number of locomotives scrapped dur- 
ing the same period was about 4.557 per cent, of the 
total number in service. Upon this basis the average life 
of a freight car figures out 29.5 years, while that of a 
locomotive figures 21.9 years. Moreover, these averages 
relate principally to the kind of equipment which was 
being made ten years ago or more, when there were al- 
most no steel cars in service, and the engines were lighter 
and much less durable than those now made. On the 
other hand, both cars and locomotives cease to have 
much, if any, sale value a number of years before they 
cease to be of considerable practical use to the road own- 
ing them. 

Summing up, it is a fair statement to say that the 
actual life of such equipment, as is now bought, is 17 to 



98 Sound Investing 



20 years, whereas the equipment trust bond issue of the 
typical sort is half extinguished in five years, and fully 
paid off in ten years. If $11,000,000 equipment trust 
bonds be issued for the balance, the increasing degree of 
security of the bonds outstanding may be approximately 
stated without going into exact refinements as shown be- 
low. It is here figured that the average life is 17 years, 
which is surely a moderate basis of calculation, in view 
of the fact that the actual life even of the old-style equip- 
ment was from 21 to 30 years. 

At End Equipment Bond9 Value of Equipment 
Of Outstanding Behind Them 

1st year $9,000,000 $9,411,765 

2nd year 8,000,000 8,823,530 

3rd year 7,000,000 8,235,295 

4th year 6,000,000 7,647,060 

5th year 5,000,000 7,058,825 

6th year 4,000,000 6,470,590 

7th 1 year 3,000,000 5,882,355 

8th year 2,000,000 5,294,120 

9th year 1,000,000 4,705,885 

Upon the basis of an average life of 17 years, there- 
fore, and of an issue maturing serially in 10 years, the 
security behind each $1,000 outstanding is about $1,411 
at the end of the fifth year, and approximately $1,960 
at the end of the seventh year, while at the end of the 
ninth year it is about $4,705. Because of this feature, 
it is practically safe to buy equipment trust bonds, even 
of roads of very poor credit, provided one first makes 
sure that the bond is issued in regular form. 

As a matter of fact, in the whole railroad history of 
the United States, there are only a few instances in 



Equipment Trusts 99 

which the holders of equipment trust bonds have lost 
money; and it has now become a matter of course for 
railroad receivers under court orders to ultimately pro- 
tect these issues. 

Thus experience indicates that for the investor who 
desires a high degree of safety, together with a fair in- 
come of about 4^4 to Sy 2 per cent., equipment trusts 
are very desirable. Considering both safety and yield, 
they are generally somewhat more desirable than railroad 
mortgage bonds except that it is necessary with them to 
change one's investments oftener. As compared with 
second mortgages, collateral mortgages and small 
divisional liens, they are preferable in almost every way. 
In spite of all the recent railroad receiverships the 
holders of equipment trusts have suffered but very few 
defaults, and even those which have defaulted are very 
likely to be ultimately redeemed at par. 



XII 

Street Railway Bonds 

STREET railway bonds as a class have thus far 
been inferior to steam railroad bonds, for the 
reason that, generally speaking, the finances of 
traction companies are not in a very strong condition. 
Nevertheless, the bonds of the strongest traction com- 
panies are almost equal in quality to those of the best 
steam railroads ; and the mere fact that a bond is issued 
by a street railway is no proof that it is not of the 
highest quality. The chief difference is that whereas 
there are a great many first mortgage steam railroad 
bonds which are absolutely secured by physical assets, 
the street railway bonds of similar quality are decidedly 
in the minority. 

One of the principal weaknesses of street railways is 
lack of working capital. Steam roads, as a rule, carry 
substantial amounts of cash, together with inventories, 
supplies, bills receivable and the like. These current 
assets exceed current liabilities by the equivalent of about 
30 per cent, of yearly gross earnings, while the typical 
street railway has almost no .excess of current assets 
over liabilities. 

This lack of working capital is in general due to the 
necessity of continuous expansion. The typical Ameri- 
can city increases its population about 40 per cent, every 

(101) 



102 Sound Investing 



ten years, and this necessitates large expenditures for 
new trackage and equipment on the part of the street 
railway. Hence, surplus earnings and working capital 
are always being spent for permanent improvements, 
such as tracks, equipment, etc. Steam roads are able 
to finance their improvements more largely out of new 
security issues, because they have earning power enough 
to pay the interest on the new issues. 

The greatest disadvantage of the street railway is the 
fact that its business consists almost entirely of pas- 
senger traffic. Such business, even for the steam roads, 
is much less profitable than the freight traffic, princi- 
pally because there is a more continuous and persistent 
downward pressure upon passenger fares. The voter, 
who ultimately controls railroad and public service com- 
missions, does not particularly care what the freight 
rate on coal or wheat is, because these freight charges 
which he pays are concealed in the retail prices of coal, 
flour and bread. But he does care about passenger fares, 
because these he pays directly out of his pocket money. 
This no doubt explains why in a recent year the steam 
roads of the United States earned 7.01 per cent, on the 
net capitalization, whereas the street railways the same 
year earned only 4.3 per cent. 

For the investor the chief weakness in street railway 
bonds is that the bonded debts are too heavy. In 1912 
the aggregate tangible and intangible value of all street 
railway property in the United States was about $3,313,- 
000,000, while the bonded debts totalled $2,329,- 



Street Railway Bonds 103 

000,000, so that the bonded debts represented more than 
70 per cent, of the total values. Furthermore, probably 
not less than 30 per cent, of these total values consisted 
of franchises, voting power and other intangible 
elements. Hence it is not too much to say that the bonds 
outstanding equalled or exceeded! the entire tangible 
assets of the street railways. 

These considerations should by no means drive the 
investor away from street railway bonds, for among 
them there are many excellent issues. Especially is this 
true of some of the underlying bonds of companies like 
the Interborough Consolidated of New York, the Public 
Service Co. of New Jersey, the Twin City Rapid Transit 
Co., Detroit United Railway and the Boston Elevated 
Railway. The foregoing are merely sound reasons for 
the exercise of caution. 

The tests to be applied to a street railway bond are 
similar in kind to those outlined for electric lighting 
bonds in Chapter X. Some of the more essential figures 
largely derived from the census report of 1912 are the 
following. 

Bonds at par $2,329,221,828 

Preferred stocks at market value 294,451,000 

Common stocks at market value 689,633,000 

Total tangible and! intangible assets 3,313,305,828 

Gross earnings 585,930,517 

Net earnings 253,034,161 

Surplus earnings 61,910,753 

Number of passenger cars 76,162 

Miles of track 41,064 

At par values the capital stock consisted of $1,970,- 



104 Sound Investing 



385,000 common; and $408,961,300 preferred, and the 
market values above are partly estimated of necessity. 
An estimate is necessary by way of eliminating the water 
from the aggregate valuation of street railway proper- 
ties. Net and surplus earnings in these Census figures 
are not computed by just the same methods as is usually 
done in corporation reports, so that some of the conclu- 
sions drawn below do not entirely agree with these 
figures. However, the chief points by which to test 
street railway bonds are the following: 

Ratio of tangible and intangible assets to gross 4.7 

Ratio of all said assets to net earnings 11.5 

Ratio of surplus earnings to true value of stocks.... 15.0 

Tangible assets per capita of population served $101.60 

Tangible assets per mile of track $72,290 

Tangible assets per passenger car $38,990 

The first three of these tests refer to both tangible 
and intangible assets combined, and therefore obtain 
valuations which should cover both bonds and stocks; 
but the last three refer to tangible assets only, and the 
valuations obtained might properly be represented by 
bonds only, provided some of these be debentures. The 
methods of using these tests, and the considerations 
regarding them, were so carefully set forth in Chapter 
10, that they will not be here repeated. 

Let not the investor be surprised if so-called practical 
men object to these tests upon the ground that they are 
too theoretical or abstruse. The investor's alternative 
is to accept the bonds at the valuations of the seller. 
These are usually based upon appraisals, and nothing 



Street Railway Bonds 105 

could be more theoretical, abstruse and unpractical than 
ordinary appraisals. In 1911, for example, a year when 
New Haven stock sold as high as 151, the value of the 
property was appraised by an engineer of the highest 
reputation at $263,600,000, as compared with a book 
valuation contained in the New Haven balance sheets 
of $188,300,000. The appraisal placed the property 
value $75,000,000 above its book value, thus indicating 
that the stock was in a very secure position, and straight- 
way the stock began to slump, and kept on until it had 
fallen from 151 to 43. Its high record of 1902 was 255. 
Appraisals are usually made in the interest of the seller, 
or the capitalizer, and therefore it would be contrary to 
human nature if they were not placed too high. 

Furthermore, the pithy answer to the charge that 
these tests are abstruse is that they are necessary. The 
best bond houses make but few mistakes; but the best 
of bond houses, like the best of everything else, are in 
the minority. For illustration, there are several pub- 
lishing houses which sell manuals of bond offerings ; and 
any one of these books discloses a large minority of 
bonds which quite fail to come to the hopes and expecta- 
tions of the sellers. At this writing if we open one of 
these manuals at random, to the Ds and Es, for example, 
we find the following: 

Present 
Flotation Selling 
Bond price price 

Dayton Lighting Co. 1st 5s of 1937 95 91 

Denver City Tramway 1st 5s of 1933 95 73 

Denver Gas and Electric general 5s of 1949. . . 100 90 



106 Sound Investing 



Present 
Floating Selling 
Bond price price 

Detroit River Tunnel 4%s of 1961 102 90 

Detroit United Railway cons. 4%s of 1932.... 97% 72 
Duluth Rainy Lake & Winnipeg 1st 5s of 1916. 101 95 

Eastern Pennsylvania Power refunding 5s 1939 96 84 

East St. Louis & Suburban coll. tr. 5s 1932.... 97% 86 
Empire District Electric 1st 5s of 1949 92% 73 

This list does not contain bonds of any of the numer- 
ous properties which have fallen into receivers' hands. 
Furthermore, in a great majority of instances the flota- 
tion prices are not given in these manuals, so that the 
list does not even contain any substantial proportion of 
the bonds under D and E which are selling far below 
their flotation price. The need for personal examina- 
tion on the part of the investor of the bonds he pur- 
poses to buy is unquestionable. The fact is that even 
among banks, trust companies, estates and other careful 
investors, it is only a very small minority of investment 
accounts which could be sold out for what they cost. 
Therefore, the practical method is to use these tests de- 
scribed above rather than trust wholly to the valuations 
of the makers' and sellers' bonds. It should be said, 
nevertheless, that there is probably no other class of 
business men who, if given the same opportunity to 
overcharge for their goods, would abuse that oppor- 
tunity as little as bond houses have done. 



XIII 

Steel and Iron Bonds 

AMONG the best of industrial investments are 
the bonds of steel and iron companies. They 
are not much in the public eye, because there 
is no speculative furore over these companies. Besides 
that, there is no reason why any group of our financial 
houses should be especially anxious to call public atten- 
tion to them, for the reason that there are no large new- 
issues, and therefore no necessity of creating a market 
for them. The principal merits are that they yield as 
much as 5 to 5^4 P er cent against Ay 2 to 5*4 per cent, 
for thoroughly secured railroad and municipal bonds, 
and that they are almost equally safe. Steel and iron 
companies reached mature growth before the recent 
era of bond inflation and radical methods of financing 
began. Thus it happened that the majority of these 
companies were financed largely by means of stock 
issues, instead of being loaded up with heavy bonded 
debts and burdensome fixed charges. 

It is not only the moderation of steel and iron com- 
panies in the issue of bonds, but also the growing size 
and importance of the industry that have given to these 
bonds a degree of stability not possessed by the majority 
of industrial securities. There was a time when this 
industry throve principally because of the protective 

(107) 



108 Sound Investing 



tariff, and could scarcely have faced English competi- 
tion without protection. Now, however, it is strongly 
fortified; and the earning power of practically all the 
important companies is quite sufficient to more than 
take care of interest charges without any protection at 
all. 

Even since 1903 there has been a very great change 
in the position of bonds of this class. In November 
of that year the United States Steel 5s of 1963 sold down, 
to 65--so little was their true value appreciated. There 
was a great deal of talk about the disruption of the 
Steel Corporation, and not a little speculation as to 
what would be left for the bondholders in such an event. 
People could not forget that the Carnegie Steel Com- 
pany a year or two previous to the organization of the 
Steel Corporation had been offered for sale at a mere 
fraction of the price at which it was taken into the 
combine, and they were prone to assume that steel com- 
panies were worth but little more in 1903 than in 1898. 

There was, however, a vast difference; for the con- 
sumption of steel and iron products was growing by 
leaps and bounds, and generally speaking, every ton 
of steel sold placed behind the bonds of these com- 
panies additional assets of from $2.00 to $5.00. In the 
panic of 1907 the value of United States Steel 5s was 
much better appreciated, and they sold below 82 only 
for a very short time, while their extreme lowest price 
was 78^2. It may now be justly doubted whether they 
will ever again sell at 78*4, as they did in 1907; and 



Steel and Iron Bonds 109 

that they will ever sell at 65, as in 1903, is extremely 
improbable. The enhancement of the value of these, 
and all steel company bonds, arises in one way or another 
from the facts that steel and iron are now used for so 
many more purposes than formerly, and that every one 
of our important industries consumes more steel, even 
in proportion to its increased volume of business, than 
it did a few years ago. 

These bonds are not very numerous, and might well 
be included among industrial bonds in general except 
that they have special distinctions. These are that the 
issues of steel bonds are exceptionally small in com- 
parison with the earnings of the companies; and that 
on this account the bonds themselves are superior in 
quality to other industrial issues. Some of the best 
known steel and iron company bonds are the following: 

Company Interest Maturity 

Bethlehem Steel Company 5 1926 

Bethlehem Steel Company 6 1998 

Bethlehem Steel Company 5 1942 

Buffalo & Susquehanna Iron Company. . . 5 1932 

Buffalo & Susquehanna Iron Company. . . 5 1926 

Colorado Steel and Iron Company 5 1943 

Colorado Steel and Iron Company 6 1919 

Illinois Steel Company 4% 1940 

Indiana Steel Company 5 1952 

Jones and Laughlin Steel Company 5 1952 

Lackawanna Steel Company 5 1923 

Lackawanna Steel Company 5 1950 

National Tube Company 5 1952 

Pennsylvania Steel Company 5 1917 

Pennsylvania Steel Company 6 1925 

Pennsylvania Steel Company 6 1927 

Republic Iron and Steel 5 1943 

Republic Iron and Steel 5 1940 

Rogers-Brown Iron Company 5 1940 



110 Sound Investing 



Company Interest Maturity 

Sloss Sheffield Iron Company 6 1920 

Sloss Sheffield Iron Company 4% 1918 

Tennessee Coal and Iron Company 5 1951 

Tennessee Coal and Iron Company 6 1917 

Tennessee Coal and Iron Company 6 1930 

Union Steel Company 5 1952 

United States Steel Corporation , t 5 1963 

Analyses of these bonds are very simple indeed, be- 
cause so few points have to be noticed. To be suffi- 
ciently high grade to correspond with the description 
here given, the net earnings of a steel and iron company 
should be equivalent to at least 140 per cent, of its total 
charges, including interest. Then, too, the bond issues 
themselves should be very small in comparison with 
total capitalization. If the bonded debt of a steel and 
iron company much exceeds one-third of the average 
market value of the total capitalization, then the junior 
bonds of that company are not very high grade. Of 
course the market value of the total capitalization is ob- 
tained by adding together all the stock, bonds and note 
issues at their average market prices. An important 
point, and perhaps the most important, regarding these 
bonds is that their merit rests upon the smallness of the 
bonded debt in comparison with the total earnings, and 
upon the great excess of net earnings over total charges. 
Where these features cease to exist, the special merits 
of the bonds also cease to exist. 



1 



XIV 

Short Term Notes 

SHORT term notes are a comparatively new set of 
securities, having practically originated in 1903, 
but they have a number of peculiar merits. 
Among these are their higher yields, their general 
exemption from possible consequences from tariff 
changes, their comparative independence of changes in 
earnings, and their larger degree of security than is 
afforded by other obligations showing the same yield. 

Until recently investors gave but little attention to 
notes, because there was no opportunity to invest in 
them continuously. It was well enough to buy a few of 
them for the sake of variety ; but the larger part of one's 
funds had to be kept in bonds and stocks. In 1904, for 
example, the total note sales of all leading corporations 
in the United States amounted to only about $90,359,500, 
whereas the total bond sales were approximately $914,- 
748,500. Thus one had ten times the selection in bonds 
than he had in notes. In 1914, however, our aggregate 
bond sales were about $1,436,517,900, while the notes 
sales alone were $526,345,500. As showing the larger 
choice of notes now offered to the investor, the total 
sales for a series of years are given. The figures prior 
to 1907 are approximates. 

cm) 



112 Sound Investing 



Year R. R. Notes Other Notes Total Notes Bonds plus Notes 

1903 $160,000,000 $ 27,760,000 $187,760,000 $ 822,538,200 

1904 77,000,000 13,359,500 90,359,500 914,798,500 

1905 78,000,000 13,533,000 91,533,000 1,185,789,200 

1906 118,000,000 20,463,000 138,463,000 1,340,546,700 

1907 269,160,000 60,702,700 329,862,700 1,299,419,700 

1908 175,000,000 16,341,000 191,341,000 1,380,764,000 

1909 195,980,000 31,478,000 227,458,000 1,430,330,000 

1910 212,951,000 61,753,800 274,704,800 1,417,637,100 

1911 326,948,000 67,590,000 394,538,000 1,644,670,300 

1912 377,793,300 130,991,000 508,784,300 1,625,610,500 

1913 427,229,700 164,892,000 592,121,700 1,482,556,300 

1914 421,999,000 104,346,500 526,345,500 1,436,517,900 

Thus the total of note issues has risen from a sum 
equal to about 10 per cent, of the amount of bonds plus 
notes yearly absorbed by the public, to a sum equal to 
almost 30 per cent.; for these bond sales refer not to 
the transactions on the New York Exchange, but to the 
estimated total absorption of new issues by the people 
of the United States. The investor, therefore, has a 
much wider choice of notes than formerly; and what is 
still more important is the fact that he has this choice 
constantly before him. 

Moreover, this choice seems likely to remain before 
the investor for some years to come. The popularity of 
note financing is not likely to decline materially until the 
market for low-interest or long-term bonds improves 
enough to enable corporations to raise money as econ- 
omically with bonds as they now do with notes, and to 
do so in face of the practical difficulty that in most cases 
the bonds issued instead of notes would have to be de- 
bentures. Bond financing of this kind is not likely to 
become such an easy matter, so long as there is such a 



Short Term Notes 113 

demand for high yields, and such an abundance of pre- 
ferred stocks recommended to the public by financial 
houses which formerly confined themselves to high 
grade bonds. 

Because of the greater abundance of notes and of the 
increased difficulty of distinguishing between good se- 
curities and poor, some investors have already adopted 
the policy of confining themselves almost exclusively to 
notes. Their reasons for so doing were explained by 
the secretary of a well known trust company, who said: 

"The investor cannot analyze bonds and preferred 
stocks. The one and only thing he has to rely upon for 
the safety of his money is the reputation of the firm 
from which he buys. A few years ago this was quite 
enough, as there were a dozen bond houses in the street 
who carefully examined the properties behind every 
bond they sold, and made certain that the bond was per- 
fectly good, not only in law, but in earning power and 
every other way. But now many investment concerns 
are sort of financial department stores, which carry 
most everything, good, bad and indifferent, and furnish 
you just as long a list of reasons for buying the bad 
and indifferent as for buying the good. 

"I used to buy bonds; but when they got to issuing 
bonds with nothing but stock collateral behind them, 
and not enough of that, I got tired of it. If there were 
a sort of pure food law for bonds the same as there is 
for groceries, and if each bond were labelled with the 
amount of water it contains, and with the commercial 



114 Sound Investing 



value of the physical property underlying it, then I 
would still feel like buying bonds. As it is, I don't know 
enough; and for a short cut to a fair yield with good 
security, I buy nothing but notes." 

Certain it is that the buying of notes is relatively 
simple. The main precaution is to make sure that net 
earnings are large enough to more than cover fixed 
charges; and this can be readily done without any 
searching analysis. The most conspicuous recent in- 
stance in which the investor in notes faced an em- 
barrassing situation was that of the Erie Railroad in 
1908; and in both 1907 and 1906 the total net income 
of the road was quite too small, as compared with total 
charges to give any ground for believing that the notes 
were especially secure. In 1907, fixed charges were 
$15,131,583, and net income only $19,393,212, even 
though the fiscal year 1907 was one of the greatest boom 
years the railroads ever had. 

The Erie notes, nevertheless, turned out all right, and 
that is usually the case with these short term issues. 
They are practically much more secure than their legal 
status would seem to indicate. Of course mortgage 
bonds are a prior lien to them ; but the amount of notes 
which a company has outstanding at any one time is 
usually small as compared with its funded debt. If 
then, at the time these mature, there are outstanding no 
bonds upon which the interest is simultaneously due or 
overdue, the company would have the choice of being 
placed in receivers' hands by the note holders, or else 



Short Term Notes 115 

refunding the notes, and the latter course would almost 
invariably be pursued. It is generally agreed that these 
notes, in case of a receivership, could not be treated as 
current liabilities, and that their security therefore 
usually rests upon the credit of the issuing company. 

In some cases, however, their safety is much greater 
than the credit of the company would seem to indicate. 
This was notably true of the General Motors 6s of 1915. 
These were secured by a first lien upon all the securities 
of subsidiary companies held by the parent company, 
and upon the entire interest which the parent company 
had in the plants and physical properties of its subsid- 
iaries. Thus all the best assets of the whole system 
were placed behind these notes. To make them still 
more attractive there was a sinking fund requirement 
of $2,000,000 per annum; and there were conditions in 
the trust deed preventing the subsidiaries from issuing 
prior obligations while the notes were outstanding. 
Thus it sometimes happens that a company, whose credit 
is no higher than was that of the General Motors Com- 
pany in 1912 and 1913 may issue an especially secured 
and perfectly good note. As a general rule, neverthe- 
less, it is a wise policy to buy the notes of only those 
companies whose net income before taxes and interest 
is equal to 140 per cent, or more of all fixed charges. 

In yield, the same as in security these notes rank 
between bonds and stocks. They return to the investor 
from a half of 1 per cent, to 1 per cent, more than high 
grade bonds, and from a half to 1 per cent, less than 



116 Sound Investing 



standard stocks. From a speculative standpoint they 
offer practically no attractions, since there is seldom or 
never any posibility of much profit on the principal. But 
for investment one of their strong points is the early 
maturity, and the practical absence of any loss from 
depreciation even in a bear market. In 1907, for exam- 
ple, while twenty representative mortgage bonds were 
declining 13.3 per cent., sixteen representative notes 
sold off only 10.5 per cent. 

Because of their early maturity they are also excel- 
lent collateral; and business men who want to get a 
return out of their idle bank balances can safely invest 
in them. If cash is needed before they mature, a col- 
lateral loan can easily be obtained at an interest rate 
fully covered by the return on the notes. By way of 
illustrating the excellent stability of these notes, the fol- 
lowing exhibit on page 117 is given of their action 
during the 1914 war panic: 



Short Term Notes 



117 



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XV 
Bank Stocks 

INVESTMENTS in bank stocks can be made to yield 
somewhat more than equally safe investments in 
other securities; but it requires care. Statistical 
tests of the earning power of these stocks are not so 
readily available as in the case of railroad bonds. There 
are no monthly reports of gross and net earnings to be 
guided by, and in many instances the deposits are only 
shown periodically at such times as they are required 
by State and National officials. Moreover, earnings do 
not vary in proportion to the volume of business, as do 
railroad earnings. Hence, even if the deposits were 
known to the investor at all times, that would not give 
him a sure indication as to the movement of earnings. 
The latter are affected almost as much by the changes 
in the rates of interest received on loans as in the 
amount of deposits. 

These difficulties, however, are not insurmountable; 
for by watching the movement of deposits, and also the 
movement of interest rates in the locality where the 
bank is situated, the investor can get a sufficiently 
accurate idea of changes in earnings. He must of course 
also consider the personnel of the bank's management, 
and the composition of the deposits. Deposits received 

(119) 



120 Sound Investing 



from other banks are less profitable than those received 
from individuals. 

Then, too, there are other ways in which the efficiency 
of a bank's management may be tested by the investor. 
The net earnings of a bank usually average about 2 per 
cent, or less upon its loanable deposits — by which is 
meant deposits minus cash reserve. Hence the intend- 
ing buyer may obtain a pretty good test by finding the 
proportion of net earnings to loanable deposits over a 
series of years or shorter periods ; and if this propor- 
tion of net earnings is being maintained while interest 
rates remain practically constant, or if it is rising while 
interest rates are rising, or if it is not falling more than 
it should while interest rates are falling — he may be 
fairly confident that the management is efficient. 

Another test of the safety of a bank stock is the per- 
centage of loans to individual deposits. Ordinarily it is 
evidence of unconservative methods for loans to exceed 
individual deposits by more than 3 to 5 per cent. But 
of course the kind of business the bank is doing, and 
the extent to which it acts as reserve agent must be 
taken into consideration. The larger a bank's holdings 
of bankers' deposits, the larger should be its percentage 
of call loans to total loans, so that in case it is called 
upon by other banks for funds, it will readily be able 
to raise them. 

The percentage of cash to loans is also significant; 
and here, too, the investor must distinguish between 
individual deposits and bankers' deposits, for the bank 



Bank Stocks 121 



holding a large percentage of the latter should main- 
tain a higher percentage of cash to loans. It is interest- 
ing to note that most of the banks which failed or sus- 
pended in 1907 were large holders of banks' deposits. 
Indeed, that was distinctively a bankers' panic; for the 
runs on New York were caused, not by individual de- 
positors, but rather by the heavy withdrawals on the 
part of the interior banks. Had the banks conducted 
themselves with as much courage and faith in each 
other as did their individual depositors, there probably 
would not have beeen any panic. 

With due attention to these points, the investor can 
get along very well with little or no knowledge of the 
personnel of a bank. There still remains to be consid- 
ered the danger of losses through fraudulent manage- 
ment. Of all the national bank failures from 1865 to 
1911 inclusive, 22.63 per cent, were brought about by 
frauds. The investor, however, can guard against this 
fairly well by making a practice, when purchasing stocks 
of banks whose personnel he does not know, of buying 
only the stocks of the larger banks. In them there is 
less danger from fraud because any possible amount of 
embezzlement is bound to be small in proportion to the 
total assets of the bank. 

In doing this, there is another principle which is well 
worth remembering; and this is, that as productive and 
commercial business expands, the interior and country 
banks draw more heavily upon the banks of the big 
cities such as New York, Chicago, Boston and Phila- 



122 Sound Investing 



delphia, in order to finance their own local needs. Hence 
the deposits of the banks in these large cities are apt 
to remain stationary or even decline when productive 
and commercial business is expanding rapidly, whereas 
those of the interior and smaller cities gain rapidly, in 
deposits and earning power. Thus it comes about that 
at such times it is often profitable to sell the stocks of 
the big city banks, and invest the proceeds in the stocks 
of the interior banks. As an example of this tendency, 
the heavy losses in deposits of the Chicago banks during 
a recent year are noteworthy. 

Bank. Dec. S, 1911 Nov. 26, 1912 

Cont. and Com. National Bank.... $180,043,830 ^16^505,435 

Corn Exchange National 66,534,736 56,462,116 

First National 123,453,983 110,282,806 

National City 30,713,014 26,375,386 

Merchants Loan and Trust 66,246,839 55,536,597 

Total Big Banking Institutions 878,434,945 837,009,236 

This total for the big banking institutions included 
all the banks and trust companies having more than ten 
millions of deposits. During the given year these lost 
$41,425,709. Meanwhile the New York banks and 
trust companies combined showed similar losses total- 
ing over a hundred million dollars. The country banks 
of the South were drawing upon New Orleans with 
similar results; and many of the Philadelphia and Bos- 
ton banks were also losing from the same cause. 

It is not meant that these big city banks on such occa- 
sions are apt to suffer any serious loss of earning power, 
but only that their earning power is not likely to increase 



Bank Stocks 



123 



so rapidly as that of many of the interior banks, and 
that it is therefore good investing to sell the stocks of 
the former, and buy the stocks of the latter. The big 
city banks profit the most from activity in the financial 
world, and large transactions in stocks and bonds, and 
in the flotation of new companies ; but the interior banks 
profit the most from the production of large crops, and 
large amounts of mineral and manufactured goods. 
This may readily be seen from the following compari- 
sons: 



Year 

Ended 


National Bank Earnings 


Bank Clearings 


R. R. 

Tonnage 


Farm 

Production 


N.Y. 


All 


N.Y. 


Other 


July 1, 1907 
Jan. 1, 1908 
July 1, 1908 
Jan. 1, 1909 
July 1, 1909 
Jan. 1, 1910 
July 1, 1910 
Jan. 1, 1911 
July 1, 1911 
Jan. 1, 1912 
July 1, 1912 
Jaa. 1, 1913 


12.9% 

8.8 
10.6 
12.1 

9.9 
10.4 
10.9 
10.6 

8.6 

*8*9*" 


10.16% 
10.03 

9.11 

8.88 

8.72 

9.09 

9.67 
10.03 

9.36 

*8*59" 


199.48 
87.18 
84.24 
79.27 
93.39 

103 . 59 

107.45 
97.27 
90.91 
92.37 
96.05 

100.74 


$58.09 
57.84 
53.50 
53.12 
57.39 
62.25 
66.01 
66.82 
66.75 
67.85 
70.59 
74.17 


1,741 

1,505* 

1,560 

1,845* 

1,83*5" 

1,834 


$5,2*89 

* 5,7i6 
' 5,781 
' *6,6i5 
' 5.760 

* 6,335 



Above are given the earnings of the New York 
National banks in comparison with those of all national 
banks in the United States, and the New York clearings 
contrasted with the clearings outside of New York. 
There are also given in millions of tons the freight 
traffic of all roads in the United States for the years 
ended June 30, and in millions of dollars the quantita- 
tive value of the total output of farm products in the 
United States for the calendar year. 



124 Sound Investing 



The significant showing is the manner in which the 
earnings of banks outside of New York, respond to the 
increase in mercantile and productive business. The 
volume of such business is shown by the changes in 
railroad tonnage and in farm production. The 1910 
crops, for example, were very large, being worth $6,015,- 
000,000, even when valued at the twenty year average 
prices for each crop, as compared with only $5,781,- 
000,000 for the crops of the previous year. Correspond- 
ingly the earnings of all banks for the year ended 
January 1, 1911 were equal to 10.03 per cent, against 
9.67 per cent, for the year ended July 1, 1910, although 
in the meantime the earnings of the New York banks 
declined. 

The reason for the decline in the latter is to be found 
in the decrease of financial transactions, and these are 
reflected in the smaller bank clearings in New York. 
(Bank clearings above are given for six month periods, 
and stated in billions of dollars.) For the six months 
ended with January 1, 1911, the New York clearings 
were only $97,270,000,000 against $107,460,000,000 for 
the previous six months. It may be observed right 
through this period that the earnings of the New York 
banks respond pretty generally to the increase or de- 
crease in financial transactions as portrayed by bank 
clearings and stock exchange trading, and that the earn- 
ings of all banks taken together respond to changes in 
production or trade. 

Thus we arrive at the important generalization that 



Bank Stocks 125 



when trade and production are fairly active, and finan- 
cial business is dull, it is a good thing to sell the stocks 
of the big city banks and invest in those of the interior 
banks. But on the other hand when financial business, 
such as the issue and sale of new bonds, and the trading 
in stock exchange securities becomes very active, the 
earnings and deposits of the big city banks grow more 
rapidly than those of the interior banks. Hence at such 
times it is a good general policy to exchange in the oppo- 
site direction. Financial business when it becomes very 
active increases the deposits of the metropolitan banks 
very rapidly — a great deal more rapidly than the de- 
posits of the interior banks ever grow. 

Nevertheless, it should be borne in mind that all these 
statistical indications are more or less of a failure for 
the ordinary investor. The fact remains that bank 
stocks are a rich man's investment, and that it is only 
through knowing a great deal about the personnel of a 
bank, and what is going on in its private offices, that one 
can really judge the future of its stocks. 

With this knowledge it is often possible to foresee a 
great rise in the stock of a bank or trust company, and 
to profit accordingly. Without it such foresight is 
theoretically possible to the expert statistician, but is 
seldom attained in practice. In general, it is not too 
much to say that it is unwise to invest in bank stocks 
unless one has an intimate personal acquaintance with 
the man or men in direct control of the given bank. 

For the ordinary investor there is the same objection 
to bank stocks that there is to the stocks of security 



A 



126 Sound Investing 



holding companies. This is that the assets of both are 
so liquid that they can disappear over night without any 
forewarning. In the case of a bank this means that it 
is an easy matter for a loan account, which is the most 
important item among the assets of any bank, to become 
so filled up with bad loans as to render the bank in- 
solvent. This, moreover, can and sometimes does 
happen while the stock of the bank is still quoted at high 
figures and while a large majority of the stockholders 
have not the slightest intimation that the stock is not a 
perfectly good investment. 

This subject should not be dropped without some 
reference to the probable effect of the Federal Reserve 
Act upon national bank earnings. It does not seem 
probable that the new act will have any perceptible 
effect on bank earnings ; and even if it should that effect 
should be slight. Taking the worst view of it, National 
banks earn an average of about 9 per cent, on their 
capital and surplus, whereas the 6 per cent, of their 
capital and surplus to be invested in the stocks of the 
Federal Reserve banks will pay only 6 per cent. Here 
is a loss of one-third on a sum equal to 6 per cent, of 
the capital surplus. This loss figures out about $3,200,- 
000 for all National banks in the United States, whereas 
their total net earnings for the year ended June 30, 1913, 
amounted to $160,980,084. There will in fact probably 
be no loss of earning power whatever, since the greater 
flexibility of reserves and the smaller disturbance from 
crop movements, etc., should enable banks to loan a 
larger proportion of their individual deposits. 



XVI 

Railroad Junior Bonds 

THE junior bonds of railroad companies, including 
not only debentures and convertibles, but also 
collateral trust bonds and even second and third 
mortgages, require an entirely different handling from 
the genuine first mortgage bonds. The latter sell in most 
any market purely according to the degree of attractive- 
ness which their current income gives them. That is to 
say, a real first mortgage is affected not by fluctuations 
in earnings, but rather by the rise and fall in the true 
value of money and capital, as expressed chiefly in 
interest rates. When money is dear, such bonds decline 
a little, and when it becomes cheap they recover again. 
On the other hand, junior bonds fluctuate more like 
stocks. If they are pure debentures the value of money, 
or their income basis, does not influence their prices 
at all. They go up and down according to the earnings, 
prosperity and prospects of the debtor corporation. In 
this respect they are different from stocks only in 
degree; for their fluctuations respond to exactly the 
same factors, and the main difference is that their inter- 
est cannot be reduced or passed, whereas dividend pay- 
ments can be. Even with such pure debentures it is a 
part of the professional etiquette of the bond salesman 
to talk as if the income basis were a very important 

(127) 



128 Sound Investing 



consideration, and to calculate the income down to small 
fractions of 1 per cent, upon the theory that the bond 
is to be held until maturity. However, every profession 
has its fashions and fictions, and this is just a little bit 
of pardonable nonsense. 

As a matter of fact the value of the pure debenture 
is not a question of income basis at all, but rather a 
question of the future prosperity of the borrowing cor- 
poration. With prosperity ahead, such a bond may rise 
so much above its flotation price as to net the investor 
within a few years a good deal more than its income 
basis would indicate; and with adversity ahead, it may 
decline so much, and become so unsafe, that the investor 
may feel obliged to sell at a loss which would wipe out 
all his interest and part of his principal. 

In view of this uncertainty as to whether and how 
long a debenture can safely be held, its income should 
be figured not upon the basis of holding to maturity, 
but rather upon the current price of the bond. For 
instance, in the case of such a debenture paying 4 per 
cent, on par, maturing in twenty years, and selling at 
83, the yield should be regarded not as 5.40 per cent, 
but rather as 4.82 per cent. In taking the yield of such 
a bond from the bond tables, the investor is simply de- 
ceiving himself, because at any moment new or unfore- 
seen circumstances may oblige him to sell instead of 
holding to maturity. 

What is true of a pure debenture, is half true of a 
bond which is secured by assets only to the extent of 



Railroad Junior Bonds 129 

about 50 per cent., and is a third true of a second or 
third mortgage bond which is secured by assets to the 
extent of about one- third. Probably the best readily 
available method by which the investor can at once 
appraise the safety and stability of junior bonds is to 
judge from the income basis at which they are floated. 
Broadly speaking, and subject to qualifications, the best 
bonds are floated at the lowest yields, and vice versa. 
A good way to find the answer to the question whether 
one desires to purchase such a bond is to bear in mind 
the probable number of points it will decline during the 
next big bear movement in securities. These declines 
for bear movements such as those of 1893, 1903, 1907 
and 1914, may be estimated as follows: 

Flotation Income Probable Decline 

Basis in Bear Movements 

4% or less 10 points or less 

4% to 4% 11 points approximate 

4% to 5 12 points approximate 

5j to 5% 14 points approximate 

5% to 5% 16 points approximate 

5% to 6% 18 points approximate 

6% to 6Y2 20 points approximate 

Above 6Y2 Over 22 points 

By the nature of things there is nothing of precision 
about these estimates, but they are broadly and essen- 
tially true. Much depends upon the ability of the given 
company to maintain its earning power upon the floating 
supply of the given bond, and upon the policies of the 
bond house which brought it out. Some houses habitu- 
ally sell bonds at higher prices than others, and some 
habitually offer the investor better yields than others 



130 Sound Investing 



on exactly the same type of bonds. Nevertheless to 
follow the inferences which might be drawn from this 
tabulation would save the typical investor from many 
a surprise and disappointment. 

Correct analysis of the assets under a railroad junior 
bond is so intricate as to be practically impossible. In 
making such an analysis very difficult and complicated 
calculations are necessary to find out the amount of the 
prior liens upon the property covered by the junior 
issue. To find this out it is necessary to know almost 
every detail in the indenture of each of the underlying 
bonds; and besides this there is often collateral security 
regarding which information is difficult or impossible 
to obtain. Hence about the only basis for judging these 
junior issues is to be found in the earning power back 
of them. 

Doubtless the best expression of this earning power 
is the "margin of safety". By this is meant the per- 
centage of total net income remaining after the pay- 
ment of taxes, interest, rentals, and all other fixed 
charges. The figure representing this margin of safety 
is to be obtained by suffixing two decimal places to the 
surplus for dividends, and then dividing by total 
charges. Good railroad bonds invariably show a 
margin of more than 50 per cent., and when this margin 
gets down below 25 per cent, it is time for the careful 
investor to sell out for what the bond will bring. To 
hold it longer is to run the risk of witnessing a receiver- 
ship and seeing the value of the bond scaled down. 



Railroad Junior Bonds 131 

Junior bonds which are floated at a yield of 5^4 per 
cent, or over, should generally be watched very closely. 
The annual reports do not come out often enough to 
give timely warning of a slump in the intrinsic value of 
such bonds. It is therefore desirable to calculate the 
margin of safety almost every month from the earnings 
reported to the Interstate Commerce Commission. 
These may be found in any good daily or weekly finan- 
cial journal, and the method of calculation is as follows : 

Suppose that the "net from railroad," or net operating 
earnings before the deduction of taxes, are $11,000,000 
for the elapsed portion of the present fiscal year, as 
compared with $10,000,000 for the same portion of the 
previous year. This is an increase of 10 per cent., and 
we find by inspection of last year's annual report that 
the total net operating earnings for the entire year 
were $24,000,000. Taking 110 per cent, of $24,- 
000,000, the indicated net operating income for the pres- 
ent year is found to be $26,400,000. This percentage 
basis must be used instead of estimating upon the basis 
of earnings per month, because the Interstate Commerce 
Commission reports do not always include all the sub- 
sidiaries included in the reports of the Corporation. 

To obtain the total net income add in last year's 
"other income," or investment income; and if, for ex- 
ample, this were $2,500,000 the total net income in this 
case would be $28,900,000. Next the total charges must 
be deducted. To estimate these add the average yearly 
increase in charges to last year's charges. If during 



132 Sound Investing 



the past five years the average yearly increase was 
$600,000, and if last year's charges were $9,800,- 
000, then the total charges should be estimated at 
$10,400,000. Deducting these from the above total 
net income there remains an indicated surplus for divi- 
dends of $18,500,000. Suffixing two ciphers and divid- 
ing by the total net income ($28,900,000) it is found 
that the indicated margin of safety is 64 per cent., or 
that 64 per cent, of the total net income will remain 
after the payment of all charges. Owing to the lack of 
advance information as to changes in "other income" 
and charges, this method is not absolutely accurate, but 
it is a good practical method. 

Convertible bonds constitute a rather distinct class 
among junior issues, and have some attractive features. 
In theory, by purchasing a convertible bond the buyer 
obtains a speculative profit without assuming a specu- 
lative risk. If the company becomes unprosperous it is 
none the less bound to redeem its bonds at par but if it 
is highly prosperous the stock goes up so much that a 
large profit can be made by converting the bond into 
stock, and selling the stock at the high prices. Indeed, 
although the conversion privilege is what causes the 
bond to follow the rise in the stock, it is unnecessary 
in practice to convert at all ; for the bond can be directly 
sold at the high price. 

Some years ago there was quite a rage for convertible 
bonds. Between 1900 and 1906 corporations were so 
very prosperous that stock values tended steadily higher 



Railroad Junior Bonds 133 

- ■ - — ■ 

and higher and almost every convertible bond looked so 
promising as to sell substantially above the price it would 
have brought without the conversion privilege. But 
since 1907 surplus earnings, both railroad and indus- 
trial, have tended pretty steadily to diminish, with the 
result that conversion privileges are now not generally 
worth much. 

In addition to the smaller earning power of stocks the 
financial policies of the railroads themselves have 
greatly diminished the value of the convertible privilege 
in many instances. For instance, the New Haven road 
after issuing convertible 3^>s in 1906, and selling them 
at a high price, first greatly diminished their value by 
later issuing convertible 6s, and next completely wiped 
out the value of the convertible privilege by issuing 
such a flood of bonds and notes that the stock can 
never have any reasonable chance of selling enough 
above par to make the 3*4 s rise much. The Union 
Pacific in a similar manner practically destroyed the 
value of the convertible privilege of the 4s of 1927, 
through distributing some of its treasury assets, and 
reducing the common dividend from 10 to 8 per cent. 

The convertible privilege of the Baltimore and Ohio 
4j^s of 1933 is greatly injured by the losses involved 
in the Cincinnati, Hamilton and Dayton purchase, and 
the value of this privilege for the St. Paul 4j4s of 1932 
may prove to be worthless partly because of the very 
heavy investment in the Puget Sound extension. The 
Chesapeake and Ohio convertible 4j^s due 1930 had 



134 Sound Investing 



the value of their privilege practically destroyed by the 
purchase of the so-called Chicago line, and the conse- 
quent heavy increases in operating expenses and 
charges. 

With railroad bonds bought at their flotation price 
or anywhere around par, the conversion privilege is now 
seldom worth anything. If, however, they can be bought 
in a bear market during a bad break, it may be worth 
quite a good deal for a short period of time. The best 
policy then is to sell the bonds in the succeeding bull 
movement, and reinvest the proceeds in something more 
stable than junior bonds. In this way very substantial 
profits can be made without any considerable risk, and 
can be made about twice every five years. 



XVII 

Equipment Company Bonds 

LOGICALLY these are merely one type of manu- 
facturing bonds; and as such they would have 
no distinct place of their own. But in fact they 
have a distinct place which has been made for them by 
accident. The accident is that for no definite reason it 
has become a habit for equipment manufacturing com- 
panies to finance themselves principally with stock issues, 
and make only very small use of bonds and notes. 
Because of this habit these issues are better secured 
as to both assets and earning power than are a great 
many manufacturing company bonds, and are therefore 
in a separate class. 

The general practice as to the use of stock and bond 
financing was disclosed by Poor's compilation of the 
capitalization of manufacturing companies in 1910; and 
the comparison with equipment companies is as follows : 

Manufacturing Cos. Equipment Cos. 
1910 1914 

Bonded debt $ 2,585,694,207 $ 65,131,750 

Capital stock 8,233,035,721 318,900,988 

Total capitalization 10,818,729,928 384,032,738 

It is noticeable that while the bonded debt of manu- 
facturing companies generally is 23.90 per cent, of their 
total capitalization, that of equipment companies is only 
16.96 per cent. Moreover, the real difference is greater 

(135) 



136 Sound Investing 



than this, because the figures for equipment companies 
include $8,194,000 of notes. Omitting these, their 
bonded debt is only 14.83 per cent, of total capitalization. 

The superiority of equipment company bonds over 
other manufacturing bonds consists largely or wholly in 
the smaller amount of their funded debt. Their earn- 
ings are subject to as violent fluctuations as any other 
manufacturing companies. This is especially true of 
the makers of railroad equipment, and is true in a lesser 
degree of the makers of electrical equipment. Even the 
General Electric showed a decline in gross sales from 
$70,977,168 in 1908, when the high record was estab- 
lished, to $44,540,675 the following year. The sales of 
the Western Electric shrank from approximately $69,- 
000,000 in 1906 to about $32,000,000 in 1908. 

Both steam railroads and trolley companies in making 
purchases of new equipment are largely dependent upon 
the condition of the market for equipment trust bonds 
and other securities; for payment is usually made with 
the proceeds of security sales rather than out of earn- 
ings. Hence, in times of financial stress, or even in 
times like 1913 to 1915, when the demand for new 
securities is so very poor, orders for new equipment 
tend to decrease violently; and if these periods are 
prolonged, it causes a corresponding decline in the 
orders booked and in the gross sales of these companies. 

Since the quality of equipment company bonds de- 
pends so entirely upon the smallness of the issues, the 
composition of the capitalization of the leading com- 
panies is worth observing. 



Equipment Company Bonds 137 

Bonds. Notes. Pfd. Stock Com. Stock 

Amer. Car and Foundry $30,000,000 $30,000,000 

American Locomotive . $2,255,000 $5,474,000 25,000,000 30,000,000 

Pressed Steel Car 12,500,000 12,500,000 

Railway Steel Spring.. 6,783,000 13,500,000 13,500,000 

General Electric 12,293,000 101,202,000 

Western Electric 15,000,000 15,000,000 

Westinghouse Electric. 20,606,750 2,720,000 3,998,700 36,700,288 

$56,937,750 $8,194,000 $84,998,700 $233,902,288 

From the fact that moderation in the use of bond 
financing is the chief basis of the high quality of equip- 
ment company bonds, it naturally follows that when 
such a company resorts to heavy bond issues, as the 
Westinghouse Electric has done, it naturally tends to 
reduce the quality. This company has been saved, tem- 
porarily or permanently, from this tendency only by 
the large business obtained through the war in Europe. 

The American Locomotive Company has likewise 
issued a considerable amount of notes, and the total 
debt of the Western Electric equals its capital stock. 
However, the notes of the American Locomotive tend 
somewhat to reduce the investment value of its pre- 
ferred stock rather than of its bonds; and the Western 
Electric bonds have a higher standing because of the 
ownership of the company by the American Telephone 
Company, and of the large earnings upon Western Elec- 
tric Company's stock. The principal bonds and notes 
of all these companies are as follows : 

American Locomotive 5% notes. . 1915-1917 J. & J. 

Railway Steel Spring 5s 1921 J. & J. 

1st mortgage 5s 1931 A. & O. 

General Electric 3Y 2 s 1942 F. & A. 

Debentures 5s 1952 M. & S. 

Western Electric 1st 5s 1922 J. & J. 

Westinghouse Electric 5% notes. . 1917 A. & O. 

Convertible 5s 1931 J. & J. 

Walker Co. 1st 6s 1916 J. & J. 



XVIII 
Manufacturing Company Bonds 

THERE are quite a number of bonds of well 
established manufacturing companies which 
yield from 5 to 6 per cent.; and which, though 
not as good as high grade railroads or municipals, are 
nevertheless excellent and practically safe investments. 

In selecting issues of this class, one should keep dis- 
tinctly in mind the peculiarities of manufacturing com- 
pany business and bonds. Two of the most important 
of these are the violent fluctuations in earnings, and the 
relatively small liquidation value of the plants and 
equipment. These two characteristics have a most im- 
portant meaning for the investor. In a business depres- 
sion gross earnings of these companies shrink anywhere 
from 15 to 60 per cent., while those of railroads are 
falling off only 5 to 20 per cent. ; and this alone renders 
it important that the margin of safety with a typical 
manufacturing bond should be from \y 2 to 3 times as 
wide as with a railroad bond of similar quality. 

Then, too, a bond to be secure under any really cor- 
rect definition must have assets enough behind it to 
make it worth par under a forced sale. The assets of a 
majority of manufacturing concerns are worth but very 
little except when the concern is continuing in business. 
The equipment and machinery, generally speaking, is 

(139) 



140 Sound Investing 



especially adapted to produce a certain type of goods 
for a certain market; and when the market disappears, 
or when from any other reason the machinery ceases to 
produce this particular kind of goods, it almost ceases 
to be anything but "scrap iron". Even if it be machinery 
of standard types serviceable in many capacities, it is 
second hand and can be sold for only 15 to 60 per cent, 
of its original cost. 

In consequence of these peculiarities the funded debt 
of a manufacturing company should be very small in 
comparison with its total capitalization. Moreover, the 
capitalization should be figured in this connection at its 
average market value rather than its par value; and by 
this is meant that the bonded debt, in order to place 
the bonds in a strong investment position, should sel- 
dom or never exceed 35 per cent, of the average market 
value of both stocks and bonds — figuring all issues at 
their average market prices. Where manufacturing 
bonds are weak or undesirable, it is usually because 
their total is too large by this test ; and if care is taken 
in this respect the investor may safely seek in this class 
of issues an income return from a half to 1 per cent, 
larger than can be obtained in the higher grade bonds 
such as railroads, municipals and the best public utilities. 

In the ordinary analysis of these bonds, very little 
attention can profitably be given to the physical security. 
Knowledge of its true value would be very desirable if 
available; but it is not available. The physical security 
behind an industrial bond is practically incapable of 



Manufacturing Company Bonds 141 

being valued by the investor. If it were railroad mileage 
one could get some idea by comparative studies of the 
true worth per mile; but to value a plant of an indus- 
trial company would require the employment of both 
an expert appraiser and also an expert judge of the 
market for the particular product which this plant 
turned out. Hence the tests to be practically applied by 
the investor are those of earning power, and of the 
ratio of funded debt to the market value of total capi- 
talization. To give any attention to the value of plants 
and physical properties would simply place the investor 
in a position to be badly deceived by the large number 
of companies which immensely over-value their plants. 



J 



XIX 

Copper Mining Bonds 

THE bonds of copper mining companies are few 
in number and widely different in character; 
but in some of them there is not only the chance 
to get a very good investment return, but also to obtain 
at the same time options on copper mining stocks which 
occasionally become very valuable. The worth of these 
options or convertible privileges — for it is the converti- 
ble bonds that are especially attractive— depends of 
course upon the position of the copper share market at 
the time the investment is made. Such bonds rise and 
fall in sympathy with the shares, except that they do 
not fall below the prices warranted by their character 
as pure investments, no matter how low the share 
market may go. Hence in general after having selected 
the convertible bond of a good company the best time 
to buy is when prices are greatly depressed and senti- 
ment very pessimistic. 

Those who desire to seek large profits without taking 
any speculative risks may do so, often successfully, 
through the purchase of these convertible copper mining 
bonds. In avoiding the slightest speculative chance it 
is necessary to select only the most secure of such bonds, 
and then after the rise has occurred, sell them before 
the period of convertibility ends. Or, if they are held 

(143) 



144 Sound Investing 



and converted, the stock when received should be sold 
at once; for all copper stocks, however seasoned and 
high grade, should be regarded as speculations rather 
than investments for the reasons set forth in Chapter 29. 

Most important of all the attractions of these bonds 
is the speculative profits which they offer during booms 
in the copper share market. As mere bonds to hold for 
investments they are no better and yield no more than a 
great many other industrial and public utility issues of 
equal or greater merit. These booms as a matter of 
history occur about once in seven to nine years; but 
even if the investor makes a mistake of expecting one 
too early, he still may enjoy a fair return on his invest- 
ment during the period of waiting. 

Copper mining bonds are given a place in this book 
solely because of the very large profits which can occa- 
sionally be made in them without any material risk. In 
number they are so few that the principal issues may be 
enumerated. 

American Smelters Securities convertible 6s due 1926 ; 
Braden Copper Mines convertible 6s due 1919; 
Chino Copper convertible 6s due 1921 ; 
Chile Copper convertible 7s due 1923 ; 
Granby Consolidated convertible 6s due 1928; 
Inspiration Copper convertible 6s due 1922; 
Ray Consolidated convertible 6s due 1921 ; 
Tennessee Copper first mortgage 6s due 1917. 

This list, of course, is not at all exhaustive, but is 
sufficient for illustration. Bond financing is a com- 
paratively new practice on the part of copper companies, 
and it is only within a very few years that the public 



Copper Mining Bonds 145 

could be induced to believe that these bonds were really 
desirable. At first this method of financing was so 
cautiously used that the issuing company instead of 
putting out a pure copper mining bond used a sort of a 
hybrid railroad and copper bond. Reference is made to 
the Nevada Consolidated 6s, which were issued about 
eight years ago, partly for the building of the Nevada 
Northern Railroad. The bonds were convertible into 
stock at $5.00 per share; and soon after their issue the 
rise in the stock to $20.00 sent the bonds up to 400 per 
cent. In 1907 the Utah Copper Company issued 
$1,500,000 6 per cent, bonds convertible into stock at 
$20.00 and these rose in 1908 to 225. 

Arizona Commercial 6s advanced rapidly in like man- 
ner. The Boston Consolidated Copper Company in 1906 
issued $1,250,000 convertible 6s, and these sold up to 
200 before they were converted. Likewise the Utah 
Apex bonds commanded a premium of 100 per cent, 
within a few months after they were issued. Ohio 
Copper Company bonds also proved a success; and 
indeed there has been only one recent instance in which 
any legitimate copper convertible mining bond proved 
any sort of a failure. 

Copper mining bonds without the convertible privilege 
are apt to be rather inferior investments unless the issues 
are very small in total amount. Nothing is more uncer- 
tain than the underground conditions of a copper mine. 
A cave-in or a flood may at any moment result in a 
shut-down and necessitate a huge expenditure of new 



146 Sound Investing 



capital. Besides this, the life of the mine, whether it 
be a vein mine or a porphyry, is also a matter of con- 
jecture, and there is great variation from year to year 
in the amount of necessary construction expenses. 
Because of these uncertainties a copper property cannot 
conservatively be mortgaged for more than a third to 
a half of its total value; and the best practical rule for 
the investor is to regard its total value as being expressed 
by the average market prices of all its outstanding secur- 
ities. Book values with a copper mine are especially 
useless. 

In analyzing these bonds the two important points 
are the safety or security of the issue, and the proba- 
bility of a rise in price. In getting at both of these points, 
the stock into which the bond is convertible must be 
studied. Methods of analyzing copper values are 
discussed in Chapter 29. A copper mining bond, to be 
secure, must have behind it substantial ore reserves and 
large equities. That is, the market value of the capital 
stock should be equivalent to 100 to 300 per cent, of the 
par value of the total bonded debt, 



XX 

Coal Company Bonds 

COAL company bonds, when issued by well de- 
veloped companies of established earning power, 
are perfectly good and fairly high grade secur- 
ities; but in recent years the public has frequently been 
asked to subscribe to a great variety of obligations or 
equities under this name which are not really bonds at 
all. The promise of a corporation to pay, in order to 
become a genuine bond, must be secured by a mortgage 
or otherwise; and many of the coal bonds of recent 
origin are not actually secured in any way. 

Some of these have been issued against undeveloped 
or partly developed coal lands, which may or may not 
ever become profitable mining properties. There have 
been more fortunes made in the United States through 
buying new coal lands and selling them at a great ad- 
vance in price than there have through the actual mining 
of coal — excepting only the case of the anthracite prop- 
erties which represent in tonnage less than one-fifth of 
our total producing capacity. A bond issued against 
coal lands which have not reached the productive stage 
is not truly a bond unless the amount of the issue is 
materially less than the salable value of the land just 
as it stands. 

To be sure, it is a general practice of mining men to 

(147) 



148 Sound Investing 



value their properties by multiplying the estimated 
mineral contents by the estimated net profit per 
ton. This, however, is manifestly just about as 
reasonable as to estimate the value of a railroad stock 
by multiplying the surplus earnings per share by the 
estimated life of the road. In this way one would 
obtain a valuation of more than $500 for Union Pacific 
stock, even if the life of the road were placed at no 
more than 50 years, and for Reading more than $2,000 
per share. 

The whole method, notwithstanding its general use, 
should be regarded as a piece of plausible statistical 
nonsense. The Commissioner of Internal Revenue in a 
circular issued February 23, 1913, in regard to the col- 
lection of the corporation tax, said: "Values as afore- 
said should not be estimated on the basis of assumed 
salable value of the output under current operative 
conditions, less the actual cost of production. The value 
must be on the basis of the salable value en bloc of the 
entire deposit of minerals and mineralized property 
owned." The bond of an undeveloped coal company, if 
the amount of the issue materially exceeds the salable 
value en bloc, is really not a bond, but a stock mas- 
querading under another name. 

A West Virginia company a few years ago offered 
a so-called first mortgage 6 per cent, gold bond, secured 
upon a property stated to consist of 10,000 acres worth 
$16,000,000. The bond circular made no statement of 
the amount of money which up to the time of the offer- 



Coal Company Bonds 149 

■ ' II——— i ■ ' — i— 

ing had been actually invested in equipment and devel- 
opment work, but apparently this amount did not exceed 
$500,000. Adding to this $600,000 raised by the sale of 
bonds the total investment was $1,100,000. The sinking 
fund provision called for only two cents per ton, which 
was entirely inadequate. As an offset it was represented 
that the unmined coal amounted to 256,000,000 tons. 
The bonds were to mature in eighteen years, so that in 
order to provide a sufficient sinking fund production 
would have had to be at the rate of 1,666,600 tons per 
annum. 

For a property in which only $1,100,000 had been 
invested such a production was, and is, simply impossi- 
ble. It requires an outlay of $1,600,000 to $2,500,000 
varying according to geological and other conditions, 
to develop a producing capacity of 1,000,000 tons; and 
this means actual money expenditure, and not mere 
nominal cost of property. The book value of coal 
property, or the plant valuation, is usually from four 
to five million dollars per million tons of capacity. 

The buyer of the bonds here referred to had not the 
slightest prospect of obtaining a reasonable return for 
his money. If such a company were to succeed all he 
could obtain would be a moderate rate of interest on his 
money, entirely too small in view of the risk he as- 
sumed. If it were to fail, as many such companies do, 
he would sustain almost a total loss. Buying such bonds 
is like paying par for a 5 per cent, common industrial 
stock with no assets behind it, and with no chance of an 



150 Sound Investing 



increase in dividend. The buyer may lose, but he cannot 
win. 

These details are given as a means of showing the 
difference between good and bad coal company bonds. 
Amongst these bonds there are in fact not many grada- 
tions. Most of them are either quite good or entirely 
bad. The investor in the bonds of such companies as 
the Pittsburg Coal Company, the Lehigh Coal and Navi- 
gation Company, and the Consolidation Coal Company 
and many other standard coal companies gets very good 
investments, worthy of his confidence. If the real bonds 
were not so good, there would be no object in making 
the counterfeits. As showing the general relations be- 
tween earnings, capitalization, output, etc., the following 
aggregates covering five leading coal companies for the 
year 1913 are worth studying. 

Gross receipts $ 74,582,879 

Operating expenses 55,794,297 

Net earnings $ 18,788,582 

Total debts $ 81,043,120 

Capital stock 133,454,166 

Total capitalization $214,497,286 

Plant valuation $177,446,063 

Yearly production, tons 46,830,000 

Of this total output, all but about 4,000,000 tons was 
soft coal. The five companies for which these figures 
are the aggregates are among the most successful in the 
United States; and it is therefore always improbable 
that a new company can show a lower ratio of expenses 
to gross earnings, or can safely carry a higher capitali- 
zation per ton of coal. The funded debt of a sound coal 



Coal Company Bonds 151 

property should not much exceed 50 per cent, of its 
salable value en bloc, or 50 per cent, of the aggregate 
value (at average prices) of all its outstanding securi- 
ties. If the debt does exceed 50 per cent., the bonds 
should be secured by net earnings equivalent to about 
200 per cent, of fixed charges. Furthermore, the bonded 
debt begins to look high whenever it much exceeds $1.00 
per ton of soft coal produced, or $3.00 per ton of hard 
coal. 

Ordinarily the sinking fund should be at least 5 cents 
per ton of run-of-the-mine coal; but this depends upon 
the relation of funded debt to coal output. If the debt is 
small and the output large, the number of cents per 
ton may be small and vice versa. Depreciation charges 
should amount to not less than 3 per cent, on the actual 
value of the physical properties of the company; and 
where such value is not obtainable the investor may 
safely take in its place 60 to 75 per cent, of the aggregate 
market value of outstanding capitalization. 

Unless unmined coal reserves are exceedingly large, 
as in the case of the Reading Coal and Iron Co., proper 
depreciation charges can be more readily estimated in 
cents per ton. With a soft coal property these charges, 
including payments into sinking funds, should usually 
amount to 8 to 10 cents per ton, while with an anthra- 
cite property they should amount to 15 to 30 cents per 
ton. Yet insistence cannot be placed on depreciation 
charges, since some of the best and strongest coal com- 
panies do not show in their annual reports how much is 
set aside for depreciation. 



XXI 

Irrigation Bonds 

BETWEEN 1880 and 1890 there occurred a specu- 
lative boom in irrigation enterprises which did 
much to bring this class of bonds into disrepute. 
Large amounts of money were obtained for irrigation 
works through the sale of bonds and stocks; great en- 
terprises were projected; and extensive canals, some 
exceeding 100 miles in length, were planned and built. 
Too little attention was given to the questions of the 
utility of irrigation, and the profits to be derived from it, 
and nearly all of these schemes resulted in failure. They 
served to extend the area of irrigation, and incidentally 
to impoverish the investors who bought the bonds. In 
1880 the irrigated area in the United States was prob- 
ably about 1,000,000 acres, while in 1889 it was 3,631,381. 
Irrigation, to be successful, requires intensive farming 
and involves a huge amount of labor per acre cultivated, 
together with great care in the application of water. It 
is not, in any sense, an easy or get-rich-quick method of 
farming. In this country farming generally is extensive 
rather than intensive, because land is abundant and labor 
is dear. It therefore generally pays better to economise 
on the labor by cultivating a large area through the use 
of machinery. It does not pay, under the prevailing 
agricultural conditions, to put forth the high labor ex- 

(153) 



154 Sound Investing 



penditure which irrigated land requires, because, with 
exceptions, the same crops can be produced more 
cheaply through extensive farming. 

Still, as the density of population grows, intensive 
farming is bound to become more and more profitable, 
and irrigation to become more general. Already there 
are exceptions enough to the above broad rule, so that 
the area of irrigated land is doubling about once in ten 
or twelve years. These bonds, then, may again have 
their day ; and not only for this reason but also to enable 
the investor to immediately recognize the occasional ir- 
rigation bond issues of doubtful value, this subject de- 
serves some attention. 

The principal irrigation bonds now on the market in 
the eastern states are the "irrigation district" bonds. The 
irrigation district is a minor civil division, constituted 
for purposes of taxation and is similar legally to a small 
municipality. The bonds are authorized by the voters of 
the district; their legality is passed upon by the district 
court; the tax levy for irrigation purposes is fixed by 
the county commissioners ; and the tax itself is collected 
along with ordinary taxes by the county treasurer. 

The lands are usually arid when the bonds are author- 
ized and sold, and therefore these are virtually construc- 
tion bonds — being issued not against actually existing as- 
sets and earning power, but against an undeveloped enter- 
prise. If they were obligations of a strong municipality 
of high credit, instead of being those of a rural district, 
they would be first class bonds. Rural districts, how- 



Irrigation Bonds 155 



ever, are not distinguished either for their sound manage- 
ment, or for their scrupulous regard for the rights of 
capital; and therefore these bonds are semi-specula- 
tive. They are comparable in general character only 
with those of the smallest municipalities, and are broadly 
inferior even to these. 

Bonds issued by companies operating under the Carey 
Act, passed in 1894 and amended in 1896, are better, 
as such projects are under the supervision of the gov- 
ernment of the United States and of the given State. 
Plans and estimates must be filed and must be approved 
by the Secretary of the Interior, the State Land Com- 
mission and the State Engineer. The land is then with- 
drawn from the public domain, and given by the United 
States to the State. Later it is sold by the latter to the 
farmer at a nominal price of about 50 cents an acre. 
Meanwhile the State gives the irrigation company a 
prior lien on the land, and the title does not pass to the 
farmer until he has actually settled on the land and paid 
the company for his water rights. These usually cost 
him from $25 to $50 per acre, and are paid for in instal- 
ments. When the payments are complete, the irrigation 
works are handed over to the farmers who use the 
water, and the irrigation company goes out of existence. 

Such bonds, therefore, represent a temporary loan by 
the irrigation company under government supervision to 
the farmer. All the profit the company can get is the 
difference between the cost of construction and the ag- 
gregate price paid by the farmers for the works. The 



156 Sound Investing 



bond does not represent any permanent investment, 
and is not attractive either to bond houses or to eastern 
investors. The bonds, while they are outstanding, are a 
lien on both the water rights and the land; but when 
they are issued they are virtually construction bonds. 
Their superiority over irrigation district bonds lies in 
the fact that whereas both classes of bonds ultimately 
depend upon the success of the project, the Carey Act 
projects are the more likely to succeed, because they are 
the most carefully examined in advance by real experts 
in matters of irrigation. 

There is a third important form of irrigation which 
should be mentioned, since it competes with these two, 
even though under this third form no bonds are issued. 
Reference is made to the irrigation projects conducted 
by the United States government under the National Irri- 
gation Act of 1902. Under this form the Secretary of 
the Interior lets contracts for the construction of irriga- 
tion works and fixes the annual instalments to be paid 
by the settlers. The works are built at the expense of 
the government, but the settler must pay to the govern- 
ment the charges against his tract of land, and must re- 
claim at least 50 per cent, of his land for agricultural 
purposes within a reasonable time. When the payments 
for the given area are barely completed by the settlers, 
the management of the works passes to the land-owners, 
subject only to the supervision of the Secretary of the 
Interior; but the title to the reservoirs and works still 
belongs to the United States. 



Irrigation Bonds 157 



The following are some of the more important statis- 
tics of irrigation collected by the United States Census 
Bureau : 



1909 1899 1889 

Number of farms in arid region.. 1,439,023 1,095,675 



Area (acres) in arid region 1,161,385,600 1,161,385,600 

Improved land in farms (acres).. 173,433,209 119,709,592 

Number of farms irrigated 157,862 107,716 54,136 

Acreage irrigated 13,739,499 7,527,690 3,631,381 

Area included in irrigated projects 31,112,110 

Total cost of irrigation systems... $304,699,450 $67,482,261 

Average cost per acre $15.76 $8.89 

Of all the farms in the arid or semi-arid region, 11.0 
per cent, were irrigated in 1909, as compared with 9.8 in 
1899. The acreage irrigated in 1909 has been classified 
according to the State and Federal laws under which 
the works were built or operated as follows : 

National Irrigation Act of 1902 395,646 acres or 2.9% 

United States Indian Service 172,912 acres or 1.2 

Carey Act 288,553 acres or 2.1 

Irrigation District 533,142 acres or 3.9 

Cooperative enterprises 4,646,039 acres or 33.8 

Commercial enterprises 1,444,806 acres or 10.6 

Individual and partnership 6,258,401 acres or 45.5 

Of the total acreage about 84 per cent, was controlled 
by cooperative, individual and partnership enterprises. 
Of the remaining 16 per cent, about 10 per cent, is in- 
cluded in what have been classified as commercial enter- 
prises — meaning those supplying water to parties who 
have no interest in the work. Of this 10 per cent., one- 
third is under the National Irrigation Act and one-tenth 
under the Indian Service, so that the striking fact is 
brought out that not more than 6 per cent, of all the 



158 Sound Investing 



irrigation projects in the United States are now con- 
ducted in such a way that bonds of private corporations 
either are, or can be, outstanding against them. 

All the reclamation and Carey Act enterprises, and 
many of the commercial enterprises are eventually to 
become cooperative. Hence the bonds of private irriga- 
tion companies form so small a class that they are hardly 
worth the attention of investors. Furthermore, they 
are so difficult to analyze that they should be let alone. 
It is only after the most thorough and personal examina- 
tion right on the ground that it is safe to buy such a 
bond. Even a personal examination involving heavy 
traveling expenses, may quite fail to reveal the truth 
since the typical investor is certainly not an irrigation 
expert. In practice, then, irrigation district bonds are 
the only class to be ordinarily considered, and these are 
semi-speculative and should be subjected to the most 
careful inquiry. 



XXII 

Light and Power Preferred Stocks 

EXCEPTING Street railway stacks, public utility 
preferred stocks are as a class about the most 
difficult of all securities to analyze or judge. 
With them analysis often amounts to little more than 
guesswork, no matter how much painstaking research 
one may make. The principal reason for this unhappy 
state of affairs is that thus far the architecture of public 
utility companies is very complicated and quite incapable 
of being understood except by insiders. A great many, 
and probably a majority, of the operating companies are 
owned or controlled by holding companies. There is 
nothing essentially objectionable about a holding com- 
pany, provided only it furnishes the investor with the 
information to which he is entitled; but this most of 
them neglect to do. 

As a usual thing, the parent concern, or holding com- 
pany, owns a portion but not the entirety of the capital 
stocks of its subsidiaries, and owns also some of the 
notes of the subsidiaries but does not own the bonds. 
In cases where the subsidiary has no short term notes 
outstanding, it very frequently owes the parent concern 
for advances made. Thus the subsidiary has outstanding 
bonds or notes or both in the hands of the public, and 
stocks partly in the hands of the public, and partly in 

(159) 



A 



160 Sound Investing 



the treasury of the holding company. In this way very 
complicated inter-corporate relations are established, and 
the investor is presented with a tangle of incomplete 
data so puzzling that its meaning can really not be 
solved. For these reasons any attempt to estimate the 
asset value of a light and power preferred stock is often 
futile, and about the best method of judging these stocks 
is to be guided first, by the architecture of the company, 
or system of companies; and second, by the earning 
power of the stocks. 

Before discussing the architecture of these companies, 
it is necessary to state what is meant by "income ac- 
counts" and "balance sheets." Many of these companies 
present certain meaningless figures under these titles, and 
the investor must distinguish sharply between the real 
thing and the empty form. A good income account will 
usually contain in one way or another the following 
items of information: 



A. Gross earnings, subdivided so as to show what portion is 

derived from light and power business, and what from 
street railway business. 

B. Operating expenses, subdivided, showing first, the cost of 

ordinary operations; and second, the cost of mainte- 
nance, repairs and sometimes depreciation. 

C. Net operating income — this being the difference between A 

and B. 

D. "Other income" — this being derived chiefly from invest- 

ments. 

E. Total net income — this being the sum of C and D. 

F. Fixed charges subdivided showing interest, taxes and de- 

preciation. 

G. Surplus for dividends, this being E minus F. 



Light and Power Preferred Stocks 161 

The omission of some of these items does not con- 
demn a company, for if it did they would nearly all be 
condemned. It is a common practice not to subdivide 
the items as herein described; but the managements of 
the stronger and more reliable companies are usually 
willing to give the stockholder any or all the foregoing 
items of information. Passing on to the definition of a 
"balance sheet/' the following items should be shown : 

ASSETS: 

Real Estate and buildings 

Gas mains, transmission lines and tracks 

Goodwill, franchises and patents 

Stocks and bonds owned 

Advances to subsidiary or affiliated companies 

Supplies and materials 

Notes and accounts receivable 

Cash on hand 

Other miscellaneous assets 

LIABILITIES: 
Common stock 
Preferred stock 
Notes outstanding 
Funded debt 
Due to subsidiaries 
Notes and accounts payable 
Accrued interest and taxes 
Reserve funds of all kinds 
Accumulated surplus 

In the following discussion "annual report" or "re- 
port" is used to mean both income accounts and balance 
sheets corresponding roughly to the foregoing descrip- 
tion, and giving a large part of the information herein 
specified. As an example of a perfectly objectionable so- 



162 Sound Investing 



called annual report, which shows nothing and treats the 
investor as if he had no rights whatever in the company 
he owns, the following are the items in the 1914 report 
of a well known public utility concern. All the items 
are quoted from the report. 

Consolidated Income and Surplus Account 

Income from operations, interest, dividends, commissions, etc. 
Deduct — Operating expenses of subsidiary, administration and 

general 
Deduct — Bond interest on parent company bonds. 
Add — Surplus as of January 1, 1914 

Deduct — Dividends paid on parent company preferred stock 
Deduct — Depreciation of securities 
Remainder equals balance carried to balance sheet 

Consolidated Balance Sheet 

Assets Liabilities 

Investments in stocks and bonds Preferred stock 

Investments in short term notes Common stock 

Notes receivable Parent company bonds 

Accounts receivable Accounts payable 

Salary and expense funds Accrued bond interest 

Cash on hand Surplus per above account 
Furniture, fittings and tools 
Goodwill of subsidiary 
Discount on securities issued 

One glance at a report like this should be sufficient to 
drive any investor away. The report shows absolutely 
nothing of the slightest interest or value to the stock- 
holder. From it he cannot learn the gross, net or sur- 
plus earnings of the company; the percentage earned on 
the stock; the amount of fixed charges; the liabilities of 
the company, including its subsidiary; the current as- 
sets; the current liabilities; or the net working capital. 
The stock of such a company, if it became very strong 



Light and Power Preferred Stocks 163 

in a run-away bull market, might be worth buying on 
margin with a sum of money which one is willing to 
gamble away; but to purchase the stock with investment 
funds from which one expects a permanent return is the 
height of folly. 

From the point of view of architecture then, let us 
mention six principal types of public utility companies, 
naming the most commendable first ; 

1. An operating company, which furnishes good income ac- 

counts and balance sheets. 

2. A holding company, which furnishes good income accounts 

and balance sheets, covering itself and all its subsidiaries 
en masse. 

3. A holding company, which furnishes reasonably good in- 

come accounts and balance sheets for itself and also for 
its subsidiaries, but not for both combined. 

4. A holding company which furnishes reasonably good income 

accounts and balance sheets for its subsidiaries, but not 
for itself. 

5. A holding company which furnishes income accounts and 

balance sheets for itself, but not for its subsidiaries. 

6. An investment company, or a holding or operating company, 

which makes no reports at all, or else meaningless reports 
such as the one above quoted. 

The degree of regard in which the preferred stocks of 
these various companies should be held, or the type of 
the stock themselves, may now be defined : 

1. Very high grade, providing surplus earnings exceed dividend 

requirements by 50 to 100 per cent, of the same. 

2. Almost equally high grade, there being no substantial dif- 

ference. 

3. Semi-speculative, since the current assets may consist of 

bills receivable by the companies from each other, while 



164 Sound Investing 



the current liabilities consist of bills payable by the com- 
panies to the public — thus making the net working capital 
wholly fictitious, or perhaps concealing large net debts. 

4. Speculative, since the debts or contingent liabilities of the 

holding company may offset all the apparent value in its 
subsidiaries, and since this form of company architecture 
is open to the same objection as Number 3. 

5. Highly speculative, because the real value of any system of 

companies lies in the operating subsidiaries, and because 
in this case nothing is shown regarding those subsidiaries. 

6. A rank speculation, because investment company assets are 

so liquid and so rapidly changing that they can vanish 
over night, and because no essential information is given. 

These descriptions relate of course to companies show- 
ing average earning power, and do not take into con- 
sideration differences in earning power. Having con- 
sidered the architecture of the company, the investor in 
preferred public utility stocks must next consider to 
what extent his rating of the given stock should be 
raised from the foregoing by exceptionally large earn- 
ing power, or lowered by unusually poor earnings. In 
the cases of Numbers 1 and 2, earnings are easily calcu- 
lated; with Number 3 a rough estimate can be formed; 
and with Number 4 a very rough estimate; Numbers 5 
and 6 should be outlawed by the investor and left en- 
tirely to the speculator who wants to take a chance of a 
haphazard kind. 

There are, however, a great many moderately strong 
public utility concerns which come under the classifica- 
tion covered by Numbers 3 and 4. Hence it is necessary 
to say a word as to methods of estimating the earnings 



Light and Power Preferred Stocks 165 

and liabilities of such companies. With these companies 

the liabilities, in the order of their priority, are: 

Subsidiary bonds 

Subsidiary notes 

Subsidiary stocks in hands of pubHc 

Parent company bonds 

Parent company notes 

Parent company net current liabilities 

Parent company preferred stock 

Parent company common stock 

It will be observed that with the ordinary holding com- 
pany here referred to, even the stocks of the subsidiary 
companies rank ahead of the parent company bonds, be- 
cause the latter derive their income from the dividends 
on these stocks; and if the dividends are not paid the 
income disappears and the bonds must default. There 
are of course some exceptions to this rule in the cases 
of subsidiary bonds held by the parent concern, or of 
non-dividend paying subsidiary stocks in the hands of 
the public. As a usual thing, however, the preferred 
stock of this type has so many liabilities ahead of it 
that the presumption is that it is a poor investment un- 
less the income accounts prove the contrary. 

With such holding companies the income available for 
the parent concern must also be estimated from the re- 
ports of the subsidiaries. The parent company usually 
styles the dividends and interest it receives from its 
subsidiaries as "total income" or "gross income" or 
"gross earnings" ; but the investor should remember that 
these names do not mean operating earnings at all. The 
most practicable method is to give up the question of 



166 Sound Investing 



gross operating earnings, and proceed at once to try to 
find out the total net income of the parent concern. To 
do this one should add to the above "total income" or 
"gross earnings" of the parent concern the surpluses 
after dividends of all its subsidiaries. If any one of 
these subsidiaries shows a deficit, this should be de- 
ducted. In doing this, the leading financial manuals are 
more useful than the reports of the companies them- 
selves, since in these manuals the statistics of all the 
subsidiaries are given with those of the parent company, 
or immediately thereafter. 

In the case of a company belonging to the fourth 
class just mentioned, the only practicable method is to 
treat the holding company as a shell, and regard its 
available income as if it were known to consist of the 
excess earnings of the subsidiaries. By this is meant the 
excess of surplus earnings over dividend payments to 
the public, and of course it must be assumed that the 
parent concern receives the dividends on the amounts of 
stocks which it holds. These amounts are almost in- 
variably stated in the manuals. With such companies 
as these the aggregate current assets and current liabili- 
ties of the subsidiaries constitute the most important 
evidence. Any estimate of surplus earnings is so unre- 
liable as to be of but little value, but estimates of net 
working capital are somewhat more reliable, and a great 
deal more valuable. 

Notwithstanding all these intricacies good light and 
power preferred stocks must be given a high rank as 



Light and Power Preferred Stocks 167 

stock investments. It is difficult to find them, and to 
recognize them when found, but they are none the less 
desirable when found and recognized. Probably after 
the public utility business has been more thoroughly de- 
veloped and standardized, more uniform accounting 
methods will be used, and subsidiaries will be consoli- 
dated with their parent concerns to such an extent as to 
largely eliminate these intricacies. 



XXIII 

Railroad Preferred Stocks 

RAILROAD preferred stocks are neither so numer- 
ous nor so popular as they were ten years ago. 
A great many of the preferred issues of former 
times have been retired, and it is not the fashion now to 
make new issues of this sort. They are not so readily 
absorbed by the public as junior bonds, and the cost of 
capital raised in this way would be somewhat higher than 
the cost of that raised through the issue of junior bonds. 

In actual character these issues are much like deben- 
tures; for they are fairly secure although not having 
mortgages or physical assets behind them, and they do 
not generally share in any bonuses or extra dividends 
which go to the common shareholders. Another point of 
resemblance is that it is almost as much of a reflection 
upon the credit of a railroad to omit preferred dividends, 
as it is to default on a debenture bond or note. The lat- 
ter involves receivership, where the former does not, 
and this is one of the principal points of difference. 

The preference enjoyed by these stocks is a safeguard 
but not a guarantee. It occasionally happens that a 
common dividend must be reduced or passed, while a 
preferred dividend is not disturbed; but the ill fortune 
required to cut off preferred dividends is only a few de- 

(169) 



170 Sound Investing 



grees worse than that required to suspend common divi- 
dends. To illustrate this point, let us observe that upon 
the basis of the 1910 railroad earnings— 1910 being the 
most recent year when railroad business was approxi- 
mately normal — it would have required only a 12 per 
cent, decrease in gross earnings to wipe out the surplus 
available for common dividends, whereas a decrease of 
14^ per cent, would have also wiped out the surplus for 
preferred dividends. This is of course upon the hy- 
pothesis that expenses and charges remain unchanged. 
The point is that in the typical case preferred dividends 
are only moderately more secure than common divi- 
dends. 

Good standard railroad preferred stocks earn at least 
1% times their dividends, or 175 per cent, thereof. A 
stock which pays 4 per cent, cannot be considered up to 
standard unless it earns 7 or more, and a stock which 
pays 5 should earn at least 8^4 per cent. A preferred 
issue earning less than 150 per cent, of its dividends 
should be considered highly speculative. 

In observing the earnings available for dividends it is 
necessary to make allowances for the very general lack 
of sufficient depreciation charges. The sums which rail- 
roads spend out of operating receipts for maintenance, 
repairs and depreciation do not fully offset the actual 
deterioration in the roadbed, equipment and terminals. 
Later on this deterioration has to be provided for, either 
out of earnings, or else by new bond or note issues ; and 
in either case the deduction from earnings, or the in- 



Railroad Preferred Stocks 171 

crease in interest charges, injures the position of the 
stocks. Hence in calculating the earnings really avail- 
able for dividends one should ordinarily deduct from 
the "surplus for dividends" as shown by the annual re- 
ports, a sum equal to about \y 2 per cent, on the valua- 
tion of "roadbed and equipment" as given in the balance 
sheet. The entire "surplus for dividends" is then con- 
sidered as being available primarily for the preferred 
stock, and secondarily for the common. 

Those who desire to use scrupulous care in the analysis 
and selection of preferred railroad shares should study 
not only the surplus for dividends, but also the intrinsic 
values behind the stocks. Stock values are seldom or 
never represented by physical property in the case of rail- 
roads, but rather by the intangible elements of value such 
as good will, rights of way, partial monopoly of a trans- 
portation field, ownership in or influence over mining 
or industrial concerns, strong banking support, and the 
like. Nevertheless, these intangible values are capable 
of being estimated. The method of doing it is entirely 
similar to that described in Chapter 27, which treats of 
railroad common stocks. Hence this method will not be 
treated here. 

As strict investments without regard to their specula- 
tive possibilities, these preferred shares are seldom very 
attractive. They usually yield only 4 7-8 to 6 per cent., 
whereas junior bonds yield almost as much. At this 
writing some of the yields on current prices are as fol- 
lows: 



172 Sound Investing 

Atchison, Topeka and Santa Fe pfd 5.10% 

Baltimore and Ohio pfd 5.67 

Chicago Milwaukee and St. Paul pfd 5.60 

Norfolk and Western pfd 5.00 

Reading Co. 1st pfd 4.84 

Reading Co. 2nd pfd 4.97 

Union) Pacific pfd 4.97 

It is not in the least difficult to obtain junior bonds, 
especially of industrial companies, which show yields 
equal to these, together with a much higher degree of 
safety. Of course a bond yielding 5.67 per cent, would 
hardly be very highly secured but there are plenty of 
them, especially of the industrial type, which are at least 
as secure as some of these preferred railroad stocks. 

As speculations, however, these stocks occasionally 
offer very substantial profits without much risk. In the 
latter part of every bear movement a study of earnings 
readily answers the question whether a preferred divi- 
dend is safe. At such times good stocks of this type 
can be bought to yield 6 or even 6^4 per cent, and some- 
times more, and the investor can be pretty sure that 
within one to three years he will be able in addition to 
the income to obtain a profit of 10 or 20 points on the 
principal. This indeed is the proper use of preferred 
railroad stocks. To hold them year in and year out 
without regard to changes in earnings and just as if they 
were mortgage bonds, is a distinct error in policy. One 
can never be certain in advance that the misfortunes of 
a business depression will not cut ofif his preferred divi- 
dends. Hence the shrewd investor will buy these stocks 
when security prices are low, and invariably sell them 
and reinvest the funds in safer and more stable securi- 
ties when stock prices become high. 



XXIV 
Street Railway Preferred Stocks 

AMONG the essential points, without which one 
cannot intelligently judge the value of a street 
railway stock, are the following: (a) Capital 
stock, (b) bonded debt, (c) current assets, (d) current 
liabilities, (e) gross earnings, (f) net earnings, (g) sur- 
plus earnings, (h) income from other sources, and es- 
pecially from sales of light or power, (i) mileage, (j) 
passengers carried, (k) free transfers issued, in cases 
where rides paid for with such transfers are counted 
among the passengers carried. With these facts it is 
possible to learn whether net or surplus earnings are 
made without injury to the property through lack of 
sufficient maintenance expenditures, and in that way to 
form a pretty clear conception of the real value of the 
stocks. 

In determining whether or not street railways are 
over-capitalized, it should be borne in mind that their 
operating expenses are lower than those of steam rail- 
roads, averaging only about 60 per cent, of gross, as 
compared with 69 per cent, for steam roads. As an 
average a street railway should show annual gross earn- 
ings equal to about 21.5 per cent, of the true value of 
its total capitalization; but it is perhaps easier to state 
the matter the other way about by saying that its total 

(173) 



174 Sound Investing 



capitalization should not ordinarily be more than 4.7 
times its gross earnings. This of course applies only to 
the road operating under typical conditions, which prac- 
tically means a road whose gross earnings are more than 
$10,000 per mile, upon which the average journey is not 
more than two to four miles, and the average receipts 
per passenger exceed 4^2 cents. Where operating ex- 
penses are exceptionally low on account of exceptional 
advantages, such as high fares per passenger, or an un- 
usual density of traffic, capitalization may exceed 4.7 
times gross without being really excessive. 

This gross-earning test for capitalization, while a good 
one and well worth using, is by no means final ; and the 
test of comparison with net earnings should also be 
applied. Under ordinary conditions capitalization should 
not exceed 11.5 times net earnings per annum; and this 
test is more reliable than the foregoing one because no 
allowances have to be made for exceptional operating 
advantages. Any such advantages are already included 
in the total of net earnings, since they can have no 
further effect than to reduce operating expenses. Hence, 
it is seldom indeed that a street railway company can be 
capitalized for much more than 11.5 times its yearly net 
earnings without being over-capitalized. 

The principal exception to this rule is the case of roads 
operating lighting and power plants; for the expenses 
and charges of these plants consume a smaller propor- 
tion of earnings than is the case with street railway 
plants; and, therefore, capitalization may properly be 



Street Railway Preferred Stocks 175 

higher. With such companies the gross earnings test 
may be applied by taking 5.4 times the gross income from 
lighting and power business, plus 4.7 times the gross 
income from the street railway business, as the theo- 
retically proper capitalization of the company. The net- 
earning test may be applied by taking 12.1 times the light 
and power net, plus 11.5 the street railway net as the 
proper capitalization. 

Having thus obtained as above the estimated intrinsic 
value of the total capitalization of the given company, 
the value of its preferred or common stock is easily ap- 
proximated. To find the value of the preferred, one 
need only deduct the par value of the bonded debt, plus 
the excess of current liabilities over current assets, (if 
there is any such excess) and divide the remainder by 
the number of preferred shares outstanding. In like 
manner the approximate value of the common stock may 
be obtained by deducting bonded debt, current excess of 
liabilities and preferred stock from the total value of 
capitalization, and dividing the remainder by the number 
of common shares outstanding. 

These tests are, of course, not absolute, but the net- 
earning test is pretty reliable, and in practice may be 
considered twice as reliable as the gross-earning test. 
Further light may be thrown upon the point by studying 
operating expenses, for where these are very high or 
very low — as compared with 60 per cent. — the gross- 
earning test is almost worthless. A company which re- 
ceives a gross income equal to less than 4.5 cents per 



176 Sound Investing 



passenger carried must have great difficulty in keeping 
net earnings up; for on the average it costs about 2.7 
cents to carry a passenger. Indeed, for the really strong 
companies receipts per passenger average very close to 
5 cents. 

Gross earnings per mile, especially in the case of in- 
terurban roads, throw valuable light upon the truth or 
fiction of the operating ratio ; for where the traffic is too 
light operating expenses necessarily consume a very 
large part of gross earnings. Even under the most favor- 
able conditions it takes about $500 per mile for main- 
tenance of way and structures, about $645 for mainte- 
nance of equipment, and about $640 for the operation of 
power plants. The heaviest expense, however, is for 
operation of cars, including wages; and under the most 
favorable conditions this requires about $2,380 per mile 
— even where the traffic is light. It is very seldom that 
total operating expenses can be reduced below $5,000 per 
mile, no matter how light the traffic may be. Hence it 
is that gross earnings of less than $6,000 per mile ought 
immediately to lead the investor to doubt the values of 
a company's stock. 

Where the gross per mile and the average fare per pas- 
senger are high enough to justify a low operating ratio, 
or where this ratio is high enough to make it pretty 
clear that it covers all operating expenses, and obviates 
drawing upon the company's capital to pay such ex- 
penses, one may safely base his estimate of the value of 
the stock upon its surplus earnings per share. 



Street Railway Preferred Stocks 177 

Street railway stocks sell higher as compared with their 
earnings than steam railroad stocks. There is no ap- 
parent reason why they should do so, as their earning 
power is more subject to popular attack; but they al- 
ways have done so, and it is safe to assume that they 
will do likewise in the future. Ordinarily a street rail- 
way stock is worth about 15.0 times its yearly surplus 
earnings per share; and when one has made sure that 
the earnings shown by the books are actually made, this 
is a pretty safe test. 

Nor should any alarm be felt over a company which 
has practically no working capital. Steam railroad com- 
panies ordinarily carry an amount of cash and other cur- 
rent assets equal to about 10 per cent, of the total value 
of their plants; and in the case of industrial companies 
it averages about 6 per cent. Some of our best street 
railways, however, have practically no working capital, 
or excess of current assets over current liabilities. 

If one wishes to be extremely careful in estimating 
the intrinsic worth of such a stock, let him first apply 
both the gross-earning and the net-earning tests, and then 
after examining the operating expenses carefully, and 
reaching a conclusion as to the amount of surplus really 
earned, apply the surplus-earning test. If a stock stands 
these three tests well, especially if the company shows a 
moderate excess of current assets over current liabilities, 
it should be regarded as a decidedly safe stock invest- 
ment. 



XXV 

Industrial Preferred Stocks 

METHODS of analyzing industrial preferred 
stocks should differ from those employed in the 
study of industrial bonds, chiefly because with 
the former the question of assets is less important, while 
the question of operating results is far more important. 
It would hardly be reasonable to expect preferred stocks 
to have behind them any large excess of assets, because 
historically the bonds and preferred stocks of most in- 
dustrial companies at the time of formation fully covered 
their entire assets, while the common stocks were issued 
against goodwill and future growth. It is proper to de- 
mand that a bond, in order to be considered a high grade 
security, should have behind it assets of 125 to 150 per 
cent. ; but it would be unreasonable to demand as much 
of an industrial preferred stock. 

These stocks are, moreover, entirely different from 
railroad issues, in that manufacturing and industrial busi- 
ness is essentially different in character from railroad 
business. Railroad revenue is by nature a sort of a tax 
upon the business of all other industries and persons. 
Our railroads in themselves produce nothing, but merely 
assist indirectly in the productive activities of others by 
facilitating the distribution of goods. Freight charges 
are therefore a form of taxation and are in general sub- 

(179) 



180 Sound Investing 



ject to the economic principles which should govern 
taxation. Because of this nature of the business done, 
railroads are not self-supporting, and should not be ex- 
pected to produce all the new capital which they require. 
On the contrary, they always have drawn, and probably 
always will draw, a considerable part of their new capi- 
tal from other industries. 

Manufacturing and industrial companies, on the other 
hand, are, or should be, self-supporting — by which it is 
meant that they should produce, or save out of earnings, 
all the capital required for their support. In conse- 
quence of this essential difference, railroad companies 
are usually capitalized at about twenty times their annual 
net earnings, while good industrial companies are capi- 
talized at only about ten times their net earnings; and 
the whole manufacturing industry of the United States, 
according to the Census, is intrinsically worth only about 
five times its annual net earning power. Of this funda- 
mental difference between railroad and industrial com- 
panies, the pith is, that it is proper and conservative for 
a railroad company to absorb more new capital than it 
produces, whereas an industrial company which does the 
same thing is apt to be in an unsound condition. 

Nor can this difference be eliminated, for new capital 
must be produced by some of our industries ; and it can 
hardly be produced by any except those which are 
essentially productive rather than parasitic. Hence the 
argument that financial methods which are good enough 
for railroads may also be practiced with impunity by in- 
dustrial concerns should be regarded as fallacious. 



Industrial Preferred Stocks 181 

Indeed the holders of preferred stocks of this class 
should in general be opposed to the increases of capitali- 
zation. A sound industrial corporation can ordinarily 
save out of earnings all the new capital required for its 
own expansion. There are, of course, exceptions, es- 
pecially in the case of acquisitions of extensive new 
plants. If these plants, however, are purchased to elimi- 
nate competition, with a view to closing them down, or 
to using them in place of old plants already owned, 
which are themselves to be closed down — then their ac- 
quisition is not a proper reason for the issue of new 
securities. Their purchase should be made out of earn- 
ings. 

An inspection of the finances of leading industrial com- 
panies quickly discloses the fact that those whose pre- 
ferred stocks are in high repute have resorted to new 
capital issues only to a very small extent. Such issues 
for the purpose of providing working capital are es- 
pecially objectionable. The net earnings of the leading 
industrial companies of the United States average about 
10 per cent, of their entire capitalization, while those of 
all manufacturing companies, according to the Census, 
average about 20 per cent. Hence, a company which has 
to resort to increased capitalization to supply working 
capital is presumably not in a strong position, and its 
preferred stocks should not ordinarily be regarded as a 
first class investment. 

Moreover, the existence of a bonded debt usually de- 
tracts more or less from the investment qualities of the 



182 Sound Investing 



preferred stock. It is not meant that industrial com- 
panies should not finance themselves through bond issues ; 
for on the contrary, capital thus secured is usually 
economical. It is meant, however, that if the interest 
charges, which must be paid in advance of preferred 
dividends, are heavy, the dividends are proportionately 
less secured; and also that if the bonded debt covers 
more than 35 or 40 per cent, of the assets of the com- 
pany, the value of a preferred stock, in case of dissolu- 
tion, would probably be small. 

In spite of these considerations, some of our best in- 
dustrial preferred stocks have bonds ahead of them. In 
these instances, however, either the bonded debt is small 
as compared with the total assets, or else the earnings 
available for dividends on the preferred stocks are ex- 
ceptionally large. 

Working capital is also an excellent, and almost neces- 
sary, test of the investment value of these preferred 
stocks. It is, however, not so much the amount of work- 
ing capital which should be examined, nor is the amount 
of working capital per preferred share especially sig- 
nificant. The essential question is whether the market 
value of the company's securities reflects the increase in 
the working capital which is shown by the company's 
balance sheets. Of course by working capital is meant 
excess of current assets over current liabilities; and 
fictions of bookkeeping are employed in calculating these 
items often enough, so that it is not safe to assume that 
this excess truly represents the amount of working capi- 
tal actually possessed. 



Industrial Preferred Stocks 183 

If the working capital shown by the balance sheet is 
actual, it is almost certain to be reflected by an increase 
in the market value of the company's securities, or at 
least by a relative increase. If the general list is ad- 
vancing, the securities of such a company will rise more 
than those of other companies; if it is declining, its 
securities will decline less than those of other companies. 
Hence, when balance sheets exhibit a pretty steady and 
large increase in working capital, which is not at all re- 
flected in the average market value of the company's 
stocks, one may be pretty sure that the increase consists 
largely of bookkeeping fictions. 

The earnings of a good industrial preferred stock 
should ordinarily be at least double the dividend rate; 
for allowance must be made for the large shrinkage in 
earnings which invariably occurs in years of depression. 
An industrial company which is in a strong position can 
safely draw upon surplus to a limited extent; but or- 
dinarily a company which cannot earn its preferred divi- 
dend in good years and bad is not in a very strong posi- 
tion. Among the leading preferred industrials there are 
very few of high standing whose earnings do not amount 
to at least twice the dividend rate. 

Stability of earnings should also be considered, but 
with these stocks it is not an especially important consid- 
eration. If the average of earnings is satisfactory, and 
if even in lean years a company does not fail to earn its 
preferred dividend, it is not a detriment of much conse- 
quence if the shrinkage of income in times of depression 



184 Sound Investing 



is pretty large. In this respect preferred industrials are 
in a different position from the common issues, not only 
because they have a prior claim upon earnings, both cur- 
rent and accumulated, but also because they generally 
represent real value, whereas the common stocks are 
more apt to represent equities, good-will and future 
prospects. 

For the practical investor the following rules may be 
laid down, subject of course to a reasonable variation 
where exceptional conditions exist. 

Increases of capitalization, except for the purpose of 
acquiring new plants, which carry with them a propor- 
tionate increase in the volume of business done, should 
at once arouse doubts as to the investment value of a 
preferred stock. 

Earnings available for preferred dividends, in order to 
render the issue high grade, should be about double the 
dividend rate; and in the case of a company having a 
bonded debt, they should be more than double. 

Working capital, as disclosed by balance sheets, should 
show an increasing tendency, except in years of business 
depression ; and these increases should not ordinarily be 
regarded as genuine, unless they are reflected in the 
prices of the company's securities. 

The bonded debt should not in any event exceed 50 
per cent, of the aggregate market value of all outstanding 
securities; where it exceeds 35 per cent., earnings on 
the preferred stock should be exceptionally large. 

Industrial preferred issues which stand these tests 



Industrial Preferred Stocks 185 

may be bought with little or no hesitation, even under 
unsatisfactory business and political conditions. Indeed, 
such issues are good investments and are likely to gain 
upon railroad investments in popularity. The yield to 
be obtained by their purchase is much larger than in the 
case of railroads, and the additional risk is not an impor- 
tant consideration. 



XXVI 

Mill Stocks 

MILL stocks are, of course, industrial stocks of 
the manufacturing type; and generally speak- 
ing, an industrial-manufacturing proposition is 
quite too speculative to be called by so dignified a word 
as "investment". This speculative character is based 
principally upon the violent fluctuations in earnings ; and 
mill earnings are particularly subject to these violent 
fluctuations. A student of the industry, unfamiliar with 
the history of the prices of mill stocks, would certainly 
draw the conclusion that such issues would be highly 
speculative — in almost the same class with mining 
shares, for example. 

As an instance of this violent change in earnings, the 
Boston News Bureau said on July 23, 1912: "It is esti- 
mated that about 35,000 out of the total of 54,000 New 
Bedford looms are idle, which would indicate that 66 
per cent, of the total output has been shut off. The ac- 
tual enforced curtailment is not so large, but is never- 
theless large enough." It was also shown that the Mano- 
met Mill, which is among the strongest of all those in 
New Bedford, earned in 1911 only $174,562 against 
$299,848 in 1910. Here was a decrease of $125,286 in 
net earnings, but dividend payments were reduced only 
$10,000. These were $160,000 for 1911 against $170,000 
for 1912. 

(187) 



188 Sound Investing 



These facts serve to illustrate the general tendency of 
mill management. Dividends are far more constant than 
earnings; and in boom years the mills do not pay in 
dividends anything like the amounts they could afford to 
pay, but rather accumulate the surplus for a rainy day. 

Forty-two New England mills in 1911 paid average 
dividends of only 4.2 per cent, as compared with 7.2 
per cent, the previous year; and these forty-two mills 
represented an aggregate capital of $37,000,000 and 
about 3,700,000 spindles. In absolute amount the divi- 
dend payments were reduced from $1,815,700 to $1,059,- 
400. (Of course the above averages, namely, 7.2 and 
4.2, are simply the averages of the individual dividend 
rates.) Here was a shrinkage in dividend payments 
of $756,300 and the decline in surplus earnings was three 
or four times that amount. 

These facts make it clear that earnings fluctuate 
enough to render the stocks very unstable and specula- 
tive; but, on the contrary, the stocks are exceptionally 
stable and a majority of them are fairly good invest- 
ments. As to the matter of stability there has been no 
little misunderstanding. A well-known authority on in- 
vestments said: "Stocks as a class sadly need even the 
slight supervision that listing achieves; and as for sta- 
bility even high-grade shares, such as those of New Eng- 
land banks and mills, suffer badly at times in liquida- 
tion, for lack of a broader market." 

Such an inference, if based upon changes in earnings, 
is natural enough, but it does not tally with the facts. 



Mill Stocks 189 



Intrinsically railroad stocks ought to be more stable than 
mill stocks, because earnings are more stable, and be- 
cause railroad income is in the nature of a sort of a tax 
upon all other business — a tax most of which has to be 
paid in fat years and lean. Mill business, however, is a 
question of new clothes, and when times are hard peo- 
ple wear their old clothes. In spite of this reasoning 
thirty representative mill stocks during the year 1907 
declined only from $121.60 to $97.76, whereas twenty 
representative listed railroad shares declined from $131.- 
95 to $81.41. The mill shares declined $23.85 or 19.61 
per cent., while the railroad shares declined $50.54 or 
38.31 per cent 

Listing, generally speaking, is a decided advantage, 
and this is particularly true of the stocks of large cor- 
porations; for such securities need a wide market com- 
posed of a vast number of investors. The principal 
advantages of listing are the supervision and publicity 
involved, and the constantly ready market in which the 
investor may always sell without delay. However, there 
are also disadvantages, and this is especially true of 
small companies which do not need a wide market. 
Chief among these disadvantages are the large spec- 
ulative dealings and price movements which natur- 
ally result from an ever-ready market; and also the 
heavy selling in times of financial disturbance. At such 
times if a business man in need of funds with which to 
save himself from insolvency owns both mill stocks and 
railroad shares, he cannot perhaps sell the former at all 



• 



190 Sound Investing 



because the private market for them almost disappears; 
but he can sell the railroad shares on the Stock Ex- 
change at some price, and he accepts the price even 
though it be very low, rather than go into bankruptcy. 

Thus the higher stability of mill stocks is partly 
genuine and partly fictitious, by which is meant that at a 
time like 1907 their prices are stable partly because there 
are not any prices, there being practically no market. 
Even this fictitious kind of stability, however, has its 
advantages, since when the market reappears the stocks 
sell somewhere near their old prices. 

In 1904 Sydney J. Chapman, Professor of Political 
Economy in the University of Manchester, England, 
wrote of the British cotton industry. "There can be no 
question that our most serious rivals are the Americans. 
In 1840 it was asserted that England possessed an ad- 
vantage in spinning over the United States of 19 per 
cent, in the cost of production. In 1878 the working 
hours (English) had fallen to 57, and the production 
had risen to 975 yards (per week of 60 hours). An 
increased production of 23 per cent, is thus due to im- 
provement in the processes of manufacture. In 1865 
there were 24,151 persons employed in Massachusetts 
in the production of cotton goods, and they produced 
175,000,000 yards. In 1875 the operatives numbered 
60,176 and their product was 874,000,000 yards. The 
operatives had increased 150 per cent, and their products 
increased 500 per cent. The increase of production due 
to improved methods was thus in England 23 per cent. 



Mill Stocks 191 



and in Massachusetts 100 per cent. Certainly a few 
years later an American weaver was managing more 
looms than an English weaver." 

Meanwhile the English weaver a few years ago was 
managing more looms than the German, or French, or 
any other. This brings out the strong point about our 
cotton mills, which is that the efficiency of our labor is 
so much higher than that of foreign labor that it partly 
offsets the higher wages. Any lowering of the tariff 
may practically compel still higher efficiency on the part 
of both employer and employee. In particular it may 
be necessary to increase the outlay of capital for new 
and improved machinery with which to make further 
economies in the cost of production. 

The stability and investment merit of mill stocks is 
clearly due to the general conservatism of management. 
Mill managements have not acquired the habit of capi- 
talizing the property at valuations so high as to cover 
present assets and future growth. Not only is total capi- 
talization usually moderate, but funded debts, where 
there are any, are ordinarily very small. Thirty-seven 
cotton mills having a total capitalization of $29,360,000 
have outstanding only $2,720,000 of bonds. Indeed only 
seven of the thirty-seven have any bonded debt at all. 

The policy usually followed as to annual reports is 
very unsatisfactory. A great many mills publish merely 
balapce sheets, and do not show earnings at all. So 
long as the management is honest, efficient and conserva- 
tive, this adds to the stability of the stock, because the 



192 Sound Investing 



investor in times of depression does not know how small 
earnings really are; but the trouble is that income ac- 
counts are needed, as a means of disclosing to stock- 
holders whether the management is honest, efficient and 
conservative. 

Variations in earnings may be roughly gauged by a 
close observance of the average prices of cotton cloth 
and of raw cotton. Both may be obtained from "Dun's 
Review"— a weekly trade publication which costs but 
little. The cotton goods prices in the table of wholesale 
quotations of commodities can readily be averaged, 
while on another page is found the prices of spot cotton. 
The margin of difference between the two, or at least the 
variations in the margins broadly reflects a correspond- 
ing variation in the gross margin of profit made by cot- 
ton mills. But of course the volume of business and 
other factors must also be taken into consideration. The 
following tabulation shows the margin of difference be- 
tween the cost of eight pounds of middling uplands 
cotton and a corresponding quantity of print cloth. In 
1910, for illustration, the price of the cloth exceeded the 
cost of the cotton by a margin which was equivalent to 
59.24 per cent, of the cost of the cotton. 



1881 


108.52 


1891 


96.90 


1901 


70.38 


1882 


9973 


1892 


118.10 


1902 


80.75 


1883 


85.79 


1893 


92.69 


1903 


66.46 


1884 


87.89 


1894 


102.47 


1904 


66.18 


1885 


85.93 


1895 


96.74 


1905 


70.66 


1886 


97.57 


1896 


74.21 


1906 


74.44 


1887 


92.58 


1897 


77.61 


1907 


106.48 


1888 


113.09 


1898 


64.90 


1908 


82.69 


1889 


108.14 


1899 


70.84 


1909 


64.90 


1890 


85.92 


1900 


81.00 


1910 


59.24 



Mill Stocks 193 



Mill stocks are good investments, but it is essential 
to possess an intimate personal knowledge of the mill 
business and mill management. In the absence of de- 
tailed income accounts and of balance sheets sufficiently 
complete to disclose the amount of working capital, 
there is no other way in which an investor can obtain a 
sufficient knowledge to form a really correct opinion 
of mill stock values. For these reasons the ordinary 
investor, who does not have this special knowledge, 
should let mill stocks alone. In this respect they are 
like bank stocks, for both offer large profits on the prin- 
cipal to the careful investor who has a full knowledge 
of personnel and finances. 



XXVII 

Railroad Common Stocks 

STOCKS are not obligations, and while this fact is 
of the most primary sort, it is so generally over- 
looked or ignored as to require special emphasis. 
Investors are continually inquiring if this or that rail- 
road stock is a safe "investment." Webster's definition 
of the word "investment" is "the laying out of money 
in the purchase of some property, usually of a perma- 
nent nature." Now there is nothing permanent about 
any railroad stock, unless it be of a company which has 
outstanding no bonds or notes and no floating debt ; and 
there are no such companies in the United States. 
Boards of directors are absolutely at liberty at any time 
to reduce or discontinue the payments of dividends upon 
either preferred or common stocks, and it does not throw 
the road into receivers' hands as would be done by a 
default of interest on bonds or notes. 

Neither are dividends always rendered practically se- 
cure by the desire of stockholders to receive returns. In 
theory railroads are in the hands of their stockholders, 
but in practice this is often untrue. The Erie for a con- 
siderable period of years was in the hands of its com- 
petitors, and its stock was owned or at least controlled, 
not for the benefit of the stockholders, but rather 
chiefly for the purpose of preventing the Erie Railroad 

(195) 



196 Sound Investing 



from aggressively competing for valuable traffic. Some- 
times, too, stock control rests in the hands of bankers 
or financing houses who are more interested in under- 
writing commissions and profits than in dividend re- 
turns. 

At other times, as in the case of the New Haven prior 
to 1913, stockholders are brought under the spell of 
some forceful individual, usually a president or a chair- 
man, who may manage the property absolutely contrary 
to the interests of these very stockholders. To enumer- 
ate all the blunders made by boards of directors (who 
are elected by stockholders) during the past ten years 
would fill this book from cover to cover. There is, 
therefore, not the slightest reason why the public should 
regard a railroad common stock, however good, as an 
investment of permanent and stable value. This value is 
subject to constant change, even in the cases of the very 
best of these stocks. 

At some time within the past decade probably not less 
than one-third of all the railroads in the United States, 
as measured by mileage, have been mismanaged. There- 
fore, the investor should have the same mental attitude 
toward a railroad stock as towards a real estate title. He 
should believe in it only after it has been examined. The 
first step in the examination is to determine whether the 
"operating expenses" of the road are really paid out of 
current earnings, or whether some of them are being 
allowed to accumulate to the detriment of the property. 
This may be done by closely observing both the ex- 



Railroad Common Stocks 197 

penses per mile over a series of years, and the percent- 
age of individual expenses to gross earnings. 

It ordinarily requires for "maintenance of way, equip- 
ment and structures" about 25 or 30 per cent, of gross 
earnings ; and about 60 per cent, of this maintenance ex- 
penditure itself goes for wages. If gross earnings are 
running steady, and a road suddenly decreases its total 
maintenance expenditures from 30 per cent, of gross 
to 28 per cent., this may be regarded as indicating that 
maintenance is being neglected. Nor are the means lack- 
ing for checking up this indication. 

Firstly, the stockholder upon application can obtain 
from the given road the last two or three annual reports 
free of charge, and can compare the itemized mainte- 
nance expenses. If, upon such a comparison, he finds 
that there has been a sharp decrease in expenditures 
for ballast, ties, rails, track materials, and for repairs 
to cars or locomotives, he can be pretty sure that the 
neglect of maintenance is a fact. Secondly, he can com- 
pare the per mile total outlays for maintenance of the 
given road with those of other neighboring roads; and 
if it is found that the other roads have not been able to 
reduce their maintenance expenditures, this is a further 
indication that the reduction on the part of this road 
represents neglect. 

Sharp distinction should be made, however, between 
maintenance expenses and transportation costs; for 
transportation costs cover such items as wages and fuel, 
and consist entirely of expenses which do not in any 



198 Sound Investing 



way improve the property or confer future benefits 
upon the road. If a company spends very heavily for 
transportation, except in the case of advance purchases 
of fuel and supplies, it is a dead loss. But if it spends 
very heavily for maintenance the heavy expenditure 
should be the equivalent of a reinvestment of surplus 
earnings in permanent improvements to the property. 
Heavy maintenance expenditures, then, may indicate 
future prosperity for the property, whereas heavy trans- 
portation costs usually indicate inefficiency of manage- 
ment. 

Both of these classes of expenses are dominated by 
the same business factors or influences. The influences 
which ought properly to reduce operating expenses per 
ton, or per passenger, or the percentage of these ex- 
penses to gross earnings, are the following: 

a. A sharp increase in gross earnings 

b. A gain in the density of traffic 
c A larger average train load 

d. A larger average car load 

e. A longer average freight haul 

f. A higher proportion of low grade freight 

g. A smaller percentage of empty freight cars 

h. A smaller percentage of passenger to total earnings 
i. Higher freight or passenger rates 

By low grade freight is of course meant heavy pro- 
ducts, such as mining and forest products, which can be 
handled easily and at a low cost per ton. A small per- 
centage of empty freight cars means the small propor- 
tion of empty cars in the typical train, and many roads 
state in their annual reports the number of loaded and 
empty cars in the typical freight train for each year. 



Railroad Common Stocks 199 

If maintenance expenses have decreased and the de- 
crease is not accounted for by one or several of these 
factors, it is a pretty sure indication of neglect. Fur- 
thermore, if maintenance costs fall while transportation 
costs do not, this in itself is an indication of neglect, 
since both are generally dominated by the same factors. 
If the investor thus reaches the conclusion that there 
is neglect, he can readily look back to years prior to 
the neglect, find the proper percentage of maintenance 
expenses to gross earnings, and thereby learn how much 
to deduct from the surplus earnings now shown by 
the books in order to obtain the genuine surplus avail- 
able for dividends. We shall find that it is necessary 
to make this correction for the purpose of using the 
true earning power of common stocks as a basis for es- 
timating their values. 

Having found this true earning power one is pre- 
pared to estimate the asset value of common stocks; 
and while judgment and discrimination are always 
necessary, a good general method is the following: 

(1) Add together these items: 

(a) Bonds issued prior to 1907 at par values 

(b) Bonds and notes since issued at their average 

market values 

(c) Preferred stocks at their average market 

value, if they are investments, and at their 
capitalized earnings if they are speculations. 

(d) Common stocks at their capitalized earnings 

(2) Deduct from the sum of these four items: 

(a) Bonds and notes at par 

(b) Preferred stock at valuation equal to 19 times 

its dividend 

(c) Net current liabilities if any 



200 Sound Investing 



Explanation of this method is as important as a mere 
statement of it. The sum of the four items named 
under (1) is regarded as the estimated total assets, 
tangible and intangible; and the next step is to deduct 
the liabilities, legal or moral, which rank ahead of the 
common stock — these being named under (2). The re- 
mainder is the estimated intrinsic value of the common 
stock issue, and the value per share may be obtained by- 
suffixing two ciphers to this estimate and dividing by 
the par value of the common stock outstanding. 

Bonds issued prior to 1907 are counted among the 
assets at par, partly because prior to that time good 
bonds were floated very close to par, and partly be- 
cause since that date most of the standard railroads 
have put back into their properties a sufficient surplus 
after dividends to make up the difference between the 
issue price of these old bonds and par. Bonds and notes 
issued since 1907 are counted at their market value, 
since their issue and flotation prices have been relatively 
low, and since their market prices may be regarded as 
the approximate equivalent of the money actually re- 
ceived by the railroads through their issue and sale. 
These market prices are generally below the flotation 
prices, and likewise the roads receive from the issue 
and sale considerably less than the flotation price, be- 
cause of the banker's commissions and other expenses 
paid. 

Preferred stocks of an investment type may repre- 
sent either tangible assets or else assets which are in- 



Railroad Common Stocks 201 

tangible, but which nevertheless are rather stable and 
permanent. Hence such stocks are counted at their 
average market value upon the theory that the assets 
behind them are roughly equivalent to this average. 
But preferred stocks of the speculative class are con- 
sidered to represent merely the present worth or dis- 
counted value of the prospects of the company; and 
they are therefore counted merely at their capitalized 
earnings — which means in practice at about 13*4 times 
their yearly surplus earnings per share. This ratio is 
based upon the fact that as an average the market 
value of standard railroad stocks is equivalent to 13^4 
times the yearly surplus earnings per share. 

In discriminating between preferred stocks of the 
investment and of the speculative types, one may 
usually by guided by the yield on the market price; for 
those yielding less than 6 per cent, are generally good 
investments, while those yielding more than this 
amount are more likely to be of a speculative nature. 
Common stocks are counted at their capitalized earn- 
ings, which also means using the above ratio of 13*4 J 
and in this calculation one should use the true earn- 
ing power of these stocks determined as described in 
the foregoing pages. 

Having thus obtained an estimate of the total assets, 
tangible and intangible, in making the deductions, both 
bonds and notes, are all counted at par, even though 
they were not so counted in the assets. This is because 
the companies must pay them off at par value even 



202 Sound Investing 



though they did not receive par for them. In these de- 
ductions the preferred stocks are counted at 19 times 
their dividend rates, because they usually sell at prices 
equivalent to this arithmetical product. If, however, 
they do not pay dividends, about the best practical 
method is to count them here at their average market 
values. Furthermore, "net current liabilities" also rank 
ahead of common stocks, and must be deducted. By 
this phrase is meant the excess of current liabilities 
over current assets. Strong roads do not show such 
net liabilities, but a great many weak roads do; and in 
calculating the amount of them, the investor will find a 
definition of terms in Chapter 45. A discussion of the 
proper uses of railroad and other common stocks will 
be found in Chapter 44, 



XXVIII 

Industrial Common Stocks 

INDUSTRIAL companies are comparatively new. 
Probably more than nine-tenths of industrial 
stocks have been issued since 1890. Partly for 
this reason, and partly because of the great diversifica- 
tion of industrial business, there has been no standardi- 
zation of accounts. Practically every company has its 
own form for constructing its annual reports, and the 
form of each company differs from that of every other 
company. Hence it is not without difficulty that indus- 
trial common stocks can be analyzed. 

Earning power is of course the most important ques- 
tion, and the real earning power of an industrial stock 
is hard to calculate, because these companies do not re- 
port any details regarding their operating expenses. 
Either they give them en masse, or else they do not give 
them at all. With a railroad it is easy to learn whether 
the reported amount of net earnings is genuine, or 
whether it represents mere bookkeeping fictions or 
technicalties ; for the railroad makes such detailed re- 
ports that it is a simple matter to learn whether operat- 
ing expenses have been fully paid or not. Therefore, 
the investor must apply general statistics to the indi- 
vidual industrial company as a test of the genuineness 
of its earnings statement. 

(203) 



204 Sound Investing 



By this it is meant that a soft coal road, for example, 
which claims to make 50 cents per ton net profit should 
be regarded with suspicion; for the general average 
profit of soft coal companies is known to be 10 to 30 
cents, and a profit of 50 cents would be so extraordinary 
as to be very improbable. Or to take a different illus- 
tration — should a steel company, in a given year, when 
steel prices went up and consumption increased, report 
a decrease in net earnings, the report should be regarded 
as being probably a mere technicality, rather than a 
statement of real conditions. 

Such methods as these have to be used in estimating 
earning power, because of the absence of the data which 
one ought to have. Some of the important points which 
would be needed to make a really accurate and scientific 
estimate of earning power are: First, total gross earn- 
ings; and second, expenses subdivided according to 
wages, materials purchased, ordinary repairs, improve- 
ment outlays, depreciation charges and bad accounts. 
Hardly any companies give these details, and indeed it 
is doubtful if there is a single company in the United 
States which gives them, and manifestly a scientific 
analysis is impossible. All that one can do is to use 
such reports as the company offers, and all the available 
general statistics, and arrive at a rough estimate of the 
yearly earnings available for dividends on the given 
stock. 

Taking this estimate of earnings as a basis, it is a 
good plan to form an estimate of the asset value or in- 
trinsic worth of the stock — remembering all the time 



Industrial Common Stocks 205 



that the assets behind industrial stocks are usually in- 
tangible. A good general method is to start with a 
valuation of the company based upon past selling prices 
of the outstanding securities, and to add thereto the 
assets which have since been accumulated out of earn- 
ings. 

One should go back five or ten years and select a 
period of two or three years when the earnings and the 
financial condition of the company were apparently 
normal, and when the condition of the industry in which 
the company is engaged was also normal. Having made 
this selection the average prices of all the securities of 
the company should be obtained, basing this average 
upon the monthly highests and lowests throughout the 
selected period. The value of these securities during 
such a normal period should be treated as if it were the 
equivalent of the true value, or asset value, of the com- 
pany at that time, or at the middle or central year of 
the given period. Adding to this hypothetical true value 
the assets accumulated out of earnings since that central 
year, plus the actual amount of new capital raised and 
invested in the properties, one obtains the present valua- 
tion of the company. Deducting from this valuation 
the bonds, short term notes, preferred stocks and net 
current liabilities, if any, one obtains the value remain- 
ing for the common stock at the present time. 

Admittedly this method consists, in a sense, of 
reasoning in a circle, but this is a merit rather than a 
defect. Average market values for, say a three year 



206 Sound Investing 



period, are so much more accurate and reliable than 
appraised values made by engineers and accountants, 
that they form a very good starting point. Besides this, 
industrial common stocks are pretty certain to sell 
around the prices or valuations arrived at in this way, 
whereas their selling prices have not the slightest rela- 
tion in the world to appraised values. 

For the sake of illustration this method of estimating 
is here applied to United States Steel common stock as 
of December 31, 1910: 

Original Assets — being based on the average 
market value of the stocks and bonds of all 
the constituent companies, 1899 to 1901..... $ 791,815,000 

Accumulated Surplus December 31, 1910, minus 
the $25,000,000 supplied at time or organ- 
ization 139,143,158 

Total Expenses for new property and new con- 
struction 362,452,383 

Paid into sinking funds to December 31, 1910. . . . 55,676,941 

Estimated total value of U. S. Steel Corpo- 
ration's assets as of Dec. 31, 1910 $1,349,087,482 

Deductions to find value remaining for common 
stock (preferred stock $360,281,100; bonds 
$596,351,867) 956,632,967 

Estimated assets remaining for common stock. . $ 392,454,515 
Same per share . , , , $77.21 

Notwithstanding the usefulness of such methods, it 
must be admitted that industrial common stocks can- 
not be successfully handled as though they were securi- 
ties of definite and constant intrinsic value. Indeed 
they are nothing of the kind. Their value is not only 
intangible but also psychological. Very often this value 



Industrial Common Stocks 207 

represents nothing more than a consensus of opinion of 
the future prospects of a given business. It is the ex- 
ception rather than the rule when such a stock is fully 
covered by even intangible assets, for the rule is that it 
represents mostly capitalized earning power or capital- 
ized expectations of future earning power. Hence it is 
that the successful method of investing in these stocks 
is to buy them, not to hold for their income, but to hold 
for a short period in order to obtain a profit on the 
principal through a rise in price. In brief, these stocks 
are generally speculations and not investments. 

Now, buying for a profit on the principal means in 
general, catching a part of the broad swings of the 
market, and these are largely identical with the broad 
swings of business prosperity. If one were to make a 
composite average of statistics reflecting business pros- 
perity — namely, bank exchanges, railroad earnings, 
steel production, foreign commerce, building operations, 
and the like — and were to draw charts of this com- 
posite average, and of the course of the stock market, 
it would be a little difficult to tell which was which. 
As a broad and consistent policy, then, the proper 
method of investing in industrial common stocks is to 
buy them just when a business depression has about run 
its course, and sell them when the next succeeding 
boom in general business is at its climax; and then to 
let them alone until the next succeeding business de- 
pression is nearing its end. 

Even so comprehensive and literally truthful a gen- 



208 Sound Investing 



eralization as this is not alone sufficient; for one needs 
to know also the governing principles which determine 
the prosperity 9f individual companies, and thereby de- 
termine first, the earning power, and second the divi- 
dend payments of their stocks. For some of the more 
important companies, these governing principles, or the 
statistics best reflecting them, may be tabulated as 
follows : 



Company Governing Principle 

Automobile Companies Total car output ; India Rubber 

imports; automobile exports. 

Agricultural Implement Cos... Farm crops and prices. 

Copper Companies Copper exports ; copper metal 

prices ; building operations ; 
railroad gross earnings. 

Electrical Manufacturing Cos.. New security issues; pig iron out- 
put; steel prices. 

Equipment Manufacturing Cos. Orders for cars and locomotives; 

railroad net earnings. 

Fertilizer Companies Value and prices of leading farm 

crops. 

Leather Companies Prices of hides and leather. 

Oil Refining Companies Illuminating oil exports; oil and 

gasoline prices. 

Petroleum Producing Cos Crude petroleum prices. 

Smelting Companies Prices of copper, silver, lead and 

spelter. 

Sugar Companies Prices of raw and refined sugar. 

Steel Companies Prices of steel; pig iron output. 

Soft Coal Companies Pig iron output ; imports of 

crude materials; freight earn- 
ings of soft coal roads. 

Woolen Companies Prices of wool and woolen cloth. 

In each instance this tabular exhibit shows, under 
the heading of "governing principle," the most useful 
available statistics in judging the fluctuations of earn- 



Industrial Common Stocks 209 

ings. By way of further explanation some comments 
are useful. 

With sugar refining companies the margin between 
raw and refined sugar is the measure of prosperity ; and 
with sugar producing companies the price of raw 
sugar is the most important. All the prices referred to 
in this Chapter can be obtained from such sources as 
Dun's Review, Bradstreet's Review, the Journal of 
Commerce, the Engineering and Mining Journal, the 
Monthly Summaries of Commerce and Finance and the 
publications of the Department of Commerce and Labor 
at Washington. 

With leather companies the margin between hides 
and leather is the measure of prosperity; while with 
woolen companies it is the margin between raw wool 
and woolen cloth. For smelting companies the above 
mentioned metal prices are a good guide, not only be- 
cause smelting charges vary somewhat with metal 
prices, but also because metal consumption goes up and 
down parallel with prices; and the big smelting com- 
panies are considerable producers of metal on their 
own account. 

Pig iron production is significant in the case of steel 
companies, because the consumption of steel is largely 
proportionate to the production of pig iron most of the 
time. In the case of fertilizer companies, the import- 
ance of the total value of crops of the United States 
as compared with the value of the same crops in pre- 
vious years, lies in the fact that fertilizer sales rise and 



210 Sound Investing 



fall with the prosperity of the farmer, whereas his 
prosperity depends upon the salable value of the crops. 

The statistics mentioned in connection with soft coal 
companies have nothing directly to do with these com- 
panies, but they form a good guide because soft coal 
consumption is largely proportionate to the variations 
in these statistics. Furthermore, the data as to soft coal 
production and consumption are usually rather stale 
before they become public. New security issues are 
significant in regard to electrical manufacturing com- 
panies, partly because electrical machinery is so fre- 
quently bought with the proceeds of new security 
issues. Moreover, the demand for such machinery is 
greatest when the construction of improvements and 
extensions is the most general, and this is the very time 
when new security issues are the largest. 

The ordinary method of study with any of these com- 
panies should be to tabulate in parallel columns the 
known earnings of the company and the general sta- 
tistics above referred to. The relation of the move- 
ment of earnings to the general movement of trade cari 
then be discovered, and the future of the earnings of 
the given company can be gauged. In this way one may 
obtain a fairly accurate idea as to the proper time to 
buy and to sell out 



XXIX 

Copper Stocks 

COPPER stocks are so different from other 
securities in every essential respect that 
methods of analysis which would be accurate in 
other fields, would lead to absurd conclusions in this. 
To begin with there is no other class of stocks so 
largely dependent upon commodity price movements as 
are these upon the price of the copper metal. Hence, 
the very first essential is to acquire a fairly good under- 
standing of the influences or economic forces which 
govern the metal. To accomplish this, it is only neces- 
sary to observe candidly a few very important facts as 
to the mining and consumption of copper; but it must 
be admitted that this open-mindedness has seldom been 
displayed, and that in consequence prevailing beliefs as 
to the future of metal prices have been too often wrong. 
Perhaps the most important of these few facts is that 
copper consumption is never very large except toward 
the close of a general boom in business. The 
metal is consumed largely in the manufacture of new 
machinery and equipment, in the erection of lighting 
and power plants, and in the construction of mills, fac- 
tories, street railway lines and telephone and telegraph 
lines. All this construction work represents improve- 
ments and extensions, and is not strictly essential to the 

(211) 



212 Sound Investing 



daily needs of the average citizen. Moreover, it is done 
chiefly in boom times, instead of being distributed in an 
even manner over a series of years. 

In consequence, the consumption of copper for a 
number of years after the end of a business depression 
depends chiefly upon maintenance and repair work, and 
a moderate amount of new construction work. Toward 
the end of a boom in business, however, when the con- 
sumption of all commodities is enormous, and the de- 
mand everywhere exceeds the available supply, there is 
a general rage to increase the plant capacity of almost 
every business; and then is the time that the consump- 
tion of copper becomes very great, and prices soar to 
giddy heights. 

This very over-consumption of general commodities, 
which leads to the demand for more plant capacity, 
and to the over-consumption of copper, also leads to a 
business depression, as it did in 1907. Hence, copper 
prices slump after a few months of excessive demand 
even more rapidly than they rose; but in the meantime 
the high prices, having lasted for a year or two, re- 
sulting in enormous mining profits, invariably have the 
effect of enticing a very large amount of new capital 
into the copper mining business. Thus it occurs that 
after the metal has slumped because of the collapse of 
the boom in general business, it is held down by the 
over-production of copper, resulting from this large in- 
flux of new capital. Hence it was that in 1908 and 1909 
copper scarcely rose at all, even though other com- 



Copper Stocks 213 



modity prices made almost a complete recovery. 
Moreover, this has been the experience of previous 
business depressions. 

The investor, therefore, must keep in mind the facts 
that for these strong natural reasons, the copper metal 
does not rise very rapidly until the boom in business is 
nearing its end. It then stays at the high prices only 
a year or two at most, whereupon it slumps and re- 
mains at the low prices three to five years. In the 
sixties the low price level lasted from April, 1866 to 
May, 1871; in the seventies from November, 1873 to 
October, 1877; in the eighties from December, 1884 to 
May, 1887; and in the nineties from December, 1891 
to July, 1898. Hence, after a financial panic, and a 
long-continued depression — the metal having remained 
at low prices four or five years — the buyer of copper 
stocks should expect a rise in the metal, and should hold 
whatever stocks he purchases, regardless of metal 
fluctuations, until the rise occurs. Still more important 
is the fact that he should not expect this rise until the 
metal market and general trade have passed through the 
experience just described. 

Only one more word need be said about metal prices; 
and that is that the prevailing theory that copper should 
move parallel to iron is supported by neither history 
nor common sense. There is probably not a single line 
of business in the word wherein iron and copper con- 
sumption rise and fall in like proportion; and even if 
there were, the production of the two metals is so en- 



214 Sound Investing 



tirely independent that there is no reason at all why 
their prices should move together. In 1890 for example, 
we produced 102.5 tons of iron to one of copper; in 
1893 the ratio was only 78.6 to one; in 1899 it was up 
to 85.7; and in 1908 it was down to 63.5. Likewise, 
the price ratio of a pound of copper to that of a ton of 
iron — meaning the ratio of the number of cents to the 
number of dollars — rose from 72.8 in 1891 to 103.3 in 
1898; then fell to 83.4 in 1900; rose to 105.3 in 1901; 
fell to 54.8 in 1902; and rose to 94.3 in 1906. Such 
theories indeed have so little sense that it is needless to 
discuss them in detail. 

Having taken into account tfee probable effect of the 
future of the metal market upon copper stock values, 
the investor should consider another important peculiar- 
ity of copper stocks. This is that notwithstanding their 
speculative character, they often sell as high and yield 
as little, at least as a rule, as good bonds, such as mu- 
nicipals and first mortgage railroads. For the twenty 
years ended with 1909 the average annual earnings 
available for dividends of all the leading copper com- 
panies in the United States was only about 2.75 per 
cent., and for the fifteen years ended with 1909 only 
about 3.25 per cent, on the market value of the 
stocks. Enough capital is always attracted into the 
business by its speculative possibilities to keep pro- 
duction so large, and prices so moderate, that the 
capital invested is able to earn only a very low re- 
turn. On this account the buyer of copper stocks may 
confidently expect to see the latter sell as high in com- 



Copper Stocks 215 



parison with their dividend payments as the best 
securities. 

Another principle is equally important to bear in 
mind, namely, that whereas other securities should be 
sold for fear of a slump when their prices become very 
high, and their yields correspondingly low, this is only 
partly true of coppers. They, on the other hand, should 
be held until both prices and yields become exception- 
ally high at the same time; for copper dividends fluctu- 
ate rapidly, and are apt to be the largest when the metal 
is the highest, since at that time earnings are so enorm- 
ous. It is for this reason that copper stocks show al- 
most their highest yields when their prices are at the 
top, although other stocks at such times show their 
lowest yields. The investor, therefore, if general busi- 
ness is booming, and prosperity is so great that manu- 
facturers in general cannot keep up with their orders, 
and the railroads cannot move the vast tonnage of 
freight laid at their terminals, should sell his copper 
stocks just when they are showing their highest yields, 
and appear the most attractive. 

Although these principles relate primarily to the 
movements of copper stock prices, rather than to the 
analysis of their values, it is proper that they should be 
discussed for the reason that these stocks are essen- 
tially speculative, are not, and cannot be "investments" 
in any true sense of the word, and therefore are not 
subject to scientific analysis. Their values are not in- 
trinsic, but rather speculative ; and owing to the sudden 



216 Sound Investing 



exhaustion of good ore which occasionally occurs, or to 
the sudden change in the character of the ore, there Is 
no real permanent security behind these values. An- 
alysis must, therefore, be made from the stock market 
point of view. 

Perhaps the method most frequently used in estimat- 
ing intrinsic values — as if the value of a copper stock 
were "intrinsic" — is to find the approximate tonnage of 
ore in the given property, also the copper contents per 
ton, and the net profit per pound of copper, and calcu- 
late therefrom the aggregate net profit to be obtained by 
extracting and selling all the copper. This aggregate 
profit is then divided by the number of shares outstand- 
ing, and it is assumed that the quotient represents the 
intrinsic value per share. 

Nothing, however, could be more utterly absurd. 
Ore reserves serve merely to insure future earning 
power. They do not represent present value, but rather 
future value; and to base an estimate of intrinsic value 
upon them is worse then counting chickens before they 
are hatched — it is counting them before the eggs are 
laid. For example, the Reading Company indirectly 
owns coal reserves of about 2,143,706,500 tons, which 
by this method of computation would give Reading 
Company common stock a value of about $1,621,150,525, 
or $2,316 per hundred dollar share. 

About all that can be done by way of "analyzing" 
copper values is to make reasonably sure that the 
management is honest, that the company has ore re- 



Copper Stocks 217 



serves enough to last for a few years, and that its cost 
of production is low enough to enable it to pay divi- 
dends with the copper metal at its average or normal 
price — which is about 14^ cents. If, however, it is de- 
sired to estimate the earning power of a copper stock, 
probably the best method is to multiply the approximate 
producing capacity by the net profit per pound of cop- 
per, and divide the total yearly profit thus obtained by 
the number of shares outstanding. Thus may be ob- 
tained the approximate yearly earning power per share, 
and by dividing this in turn by the market price of the 
shares, one may find about what percentage the stock 
is earning on its market price, and whether it is cheap 
or dear, as compared with other stocks similarly situ- 
ated. 

These stocks, at the same moment, sell at such a 
variety of prices that earnings of different stocks on 
their market values vary all the way from 3 to 16 per 
cent; and on this account, the purchaser should learn 
the percentages earned by the given stock on its market 
price for a series of years. Moreover, as these esti- 
mates of earnings are based always upon the difference 
between the cost of production and the prevailing price 
of the metal, such a comparison will tend to show 
whether or not the stock is really cheap upon the basis 
of current metal prices. While the values of these 
stocks are speculative rather than intrinsic, and not- 
withstanding that accurate analysis is impossible, there 
is no class of securities which appreciate more during a 



218 Sound Investing 



bull market, and none in which the wise purchaser can 
make so large profits. 

In obtaining the necessary statistics of production, 
costs and the like, more than ordinary care should be 
taken. The most important figures are those in regard 
to costs per pound, and copper company reports are so 
lacking in details as to throw but little light upon this 
question. Furthermore, it is a rather general and good 
practice to take out the best ore, and therefore operate 
at the lowest costs when copper metal prices are low; 
and to mine the poorer ores, in spite of the high cost of 
production, when copper metal prices are high. Hence, 
one should avoid the generally prevailing error of sup- 
posing, after a big rise in metal prices, that copper 
companies are going right on producing at the same low 
costs which they showed when metal prices were low. 
In practice they do nothing of the kind. 

In obtaining these statistics, especially of costs, it is 
to be continually remembered that the figures are al- 
most as much matters of opinion as actual statistics. 
Therefore, the best method is to read all the standard 
authorities, and take a sort of a consensus of opinion. 
One should consult such authorities as the Copper 
Handbook, the Boston News Bureau, Walker's Weekly 
Letters, and the market letters of the leading Boston 
Stock Exchange houses, especially those of the big 
houses which finance and control copper mining proper- 
ties. A consensus of opinion as to costs, obtained in 
this way, will prove to be near enough the truth to serve 



Copper Stocks 219 



as a basis for estimating the earning power of copper 
stocks. 

As to production and producing capacity, the same 
methods should be used. In the case of a new property 
it should be remembered that engineers' opinions are 
almost always too high. The conservative investor may 
well deduct 20 to 25 per cent, from engineers' esti- 
mates of producing capacity, and add one cent to one 
and a half cents per pound to their estimates of costs 
of production. Not only will this arbitrary rule come 
closer to the truth than the estimates themselves, but it 
will save the investor very many blunders. 



SECTION III 
THE PERSONAL SIDE OF INVESTING 



Personal Side of Investing 

or 

Preface to Section III 

In Section II we have noticed one by one the various 
classes of securities, and the earmarks which are valu- 
able in helping the investor to select the better issues 
out of each class. The personal side of the science of 
investing has not, however, been given the attention 
which it deserves in current financial literature. That 
it should have been so neglected seems to be an over- 
sight; for the capacity of the individual to make scien- 
tific discriminations is just as important in the invest- 
ment field as it is in law, medicine or any of the arts. 

A man out of his place is no man at all. We have 
no record of the statues carved by Alexander the Great, 
or of the battles won by Phidias; and yet right around 
us every day people are making attempts to practise 
some of the higher arts of investing for which they are 
as unfitted as was Phidias to command armies or Alex- 
ander to carve the Olympian Jupiter. The less exten- 
sive is one's acquaintance with securities, and their good 
and bad points, the more strictly he should adhere to 
the most rigid rules of selection. 

An experienced railroad engineer of long training 
may run a defective locomotive without imperiling lives, 
because he is able to immediately detect and diagnose 

(221) 



222 Sound Investing 



the first sign of danger and take the necessary precau- 
tions ; but a new man needs a perfect locomotive. Like- 
wise a stock or bond broker, for example, who is con- 
tinually studying securities is competent to select good 
from amongst such speculative issues as unsecured 
bonds and common stocks; but the clerk or laboring 
man who attempts the same thing is pretty sure to lose 
a considerable portion of his investment. 

For these reasons it is planned to here present a series 
of ten chapters devoted to the Personal Side o# 
Investing. In these an effort will be made to point out 
what classes of securities each considerable class of in- 
vestors may safely purchase; and an opinion will be 
given as to what proportion of the total investment may 
safely be put into securities showing the higher yields 
and the lesser degree of safety. The desideratum is of 
course to get the highest possible yield without sacrifice 
of principal; and the constant effort will be to outline 
the method of accomplishing this. Roughly speaking, 
the investing public may be arbitrarily subdivided into 
the following classes: 

1. Stock and bond dealers 

2. Banks, trust companies and insurance companies 

3. Railroad, industrial and manufacturing companies 

4. Trustees and estates 

5. Colleges, hospitals and other institutions 

6. Business proprietors and partners 

7. Lawyers, doctors and other professional men 

8. Salaried employees of business houses 

9. Clerks and laboring men 
10. Women and dependents 

While no hard and fast lines can be drawn, it is ap- 



Personal Side of Investing 223 

parent that stock and bond brokers, whose regular busi- 
ness it is to study investment values, should be the most 
competent to judge of the same, whereas women and 
dependents, who, as a class, have neither the opportunity 
nor the ability to make such studies, could scarcely be 
expected to acquire skill at all in judging values. As a 
general thing, the least competent judges of values set 
for themselves the most difficult tasks, such as getting 
50 or 100 per cent, return on their money; and then, 
when they fail, they draw the conclusion that money 
must not be invested in stocks and bonds. On the con- 
trary, there is no better medium of investment even for 
the man with a few hundred dollars. He can obtain a 
larger return from securities with equal safety than he 
can from a savings bank, or from real estate, or from 
most any other source. 



XXX 

Investments for Stock and 
Bond Dealers 

FOR the reasons just mentioned in the Preface to 
this Section, stock and bond brokers can afford 
to take risks which to most any other class of 
investors would almost certainly involve considerable 
losses. They can afford in the first place to use the 
most highly developed and scientific method of handling 
investments, namely, that of changing them from time 
to time in harmony with the changes in business con- 
ditions and security prices. The uninitiated, in order 
to be safe, must buy securities which are at all times 
good; but these brokers have the experience which 
should enable them to buy cheap and sell dear. In other 
words, they ought to be able to obtain not only the in- 
terest or dividend return, but also a profit on the prin- 
cipal through appreciation in price. 

The foregoing no doubt represents the most highly 
developed method of handling investments; for both 
stock and bond prices rise and fall with the ebb and 
flow of prosperity. A business depression carries stock 
prices down 25 to 50 per cent, and bonds 5 to 15 per 
cent., while a boom has the opposite effect. No one can 
sell at the top or buy at the bottom ; but those who are 
competent to judge can at least sell above average prices 

(225 ) 



226 Sound Investing 



and buy below them, or in other words, sell above in- 
trinsic values and buy below. 

The efforts should be in times of depression to so 
change one's investment list as to make it include a high 
percentage of those securities which appreciate the 
most. On the other hand, when business is booming 
and prices are inflated, the list should be so revised as 
to include a high percentage of those securities which 
in the succeeding panic or depression will depreciate 
the least. Practically expressed, this means increasing 
the proportion of common and preferred stocks, and 
debenture, convertible and other partly-secured bonds 
when prices are depressed, and increasing the propor- 
tion of equipment trusts, short term notes and bonds 
of short maturity when prices are inflated. When prices 
are below values, the following is suggested as a list 
suitable for a stock or bond broker to hold as personal 
investments : 



5 per cent in first class underlying railroad bonds yielding 

4^ to SVs% 
5 per cent, in gas company bonds yielding 4% to $V%% 
5 per cent, in street railway bonds yielding 5 to 6^% 

IS per cent, in steel and iron company bonds yielding 5% to 
63/4% 

10 per cent, in corporation notes yielding 5$i to 6}%% 

10 per cent, in bank stocks yielding 4 to 4^4% 

15 per cent, in railroad convertibles, etc., yielding 4}i to 554% 
5 per cent, in manufacturing company bonds yielding 6 to 7% 
5 per cent, in copper mining bonds yielding 6 to 7j4% 

10 per cent, in preferred stocks yielding 6 to 7 T A% 

10 per cent, in common railway and industrial stocks yielding 

sy 2 to 7% 

5 per cent, in copper stocks yielding 6 to 8% 



Stock and Bond Dealers 227 

Such a subdivision of the total investment would 
mean, when summarized, that 15 per cent, would be in 
first class bonds; 25 per cent, in good bonds or notes; 
10 per cent, in bank stocks; 20 per cent, in fairly good 
bonds; and 25 per cent, in stocks. 

The possibilities of a list of this kind are great. They 
cannot be precisely defined, because no one can know 
the future sufficiently to form a close estimate of the 
appreciation in the convertible bonds and common and 
preferred stocks. Still it is estimated that a good list 
of securities of the foregoing composition, if obtained 
during a business depression and a bear movement, and 
sold a few years later during the next ensuing boom, 
would show a pretty secure current yield of Sy 2 per 
cent, on its cost, and would also appreciate in market 
value enough to bring the total yield for the several 
years during which it was held up to about 8^4 per cent. 

It is assumed of course that the constant purpose of 
the investor will be to buy when prices are below value 
and to sell when prices are above value; and that in 
carrying out this purpose no attempt will be made to 
catch the momentary fluctuations. Broadly speaking, 
every five year period contains two bull movements and 
one bear movement. In recent times the average dura- 
tion of a bull movement has been about two years, as 
compared with one year for a bear movement. In the 
past fifty-five years there have been twenty-three main 
movements including both kinds, but this large number 
in excess of that indicated by the generalization just 



228 Sound Investing 



made is due to the frequency with which these move- 
ments succeeded each other in the period just after 
the Civil War. However, the point is that opportuni- 
ties to make money through these broad swings come 
often enough so that they are worth waiting for. 

When, in the judgment of the stock and bond 
dealer, a bull market is somewhere near the climax, it 
is manifestly desirable to dispose of such securities as 
depreciate greatly during a business depression. Thus 
the investor may place himself in a position to regard 
a bear movement as being ultimately nothing more than 
another opportunity to buy cheap. To do this he must 
hold nothing but those securities whose value remains 
almost unchanged in times of stress. Therefore the 
following diversification is suggested for such times. 

10 per cent, in U. S. government bonds yielding l$i to 3% 
10 per cent, in bonds of various states yielding 3^. to 4^4% 
15 per cent, in good foreign government bonds yielding 3^4 to 

sx% 

15 per cent, in best municipals yielding 4 to 4$4% 

25 per cent, in underlying railroad mortgage bonds yielding 4%. 

to 4^4% 
5 per cent, in gas and electric company bonds yielding 43/g to 

SH% 
15 per cent, in equipment trusts yielding 4H to 5% 
10 per cent, in short term notes yielding 4J4 to 6% 

An investment of this kind would show an average 
yield of approximately A T / 2 per cent., and will be so 
stable that its holder will be indifferent to a bear move- 
ment. From the extreme high prices of the bull move- 
ment to the extreme low prices of the bear movement, 
the depreciation is not likely, even in case of a panic 



Stock and Bond Dealers 229 

like that of 1907, to average more than 9 l /s per cent. 
Furthermore, the safety of these securities is so great, 
and their recovery so rapid that even this depreciation 
is of no practical consequence to the investor. 



XXXI 

Investments for 

Banks, Trust Companies and Insurance 

Companies 

THE second of the principal classes of investors 
consists of banks and insurance companies. 
It is not the purpose here to discuss legal re- 
strictions, because that would be quite out of place in a 
brief treatment of this kind. Every national or savings 
bank, trust company and insurance company has its 
legal department, or legal adviser, who passes upon all 
such matters. These restrictions make it impossible in 
many instances to hold just such an investment list as 
is here suggested; and besides this, it is often desirable 
to hold non-taxable securities, even though they yield 
somewhat less. However, the aim here is to present 
the method and the ideal; for it is an easy matter for 
any individual concern to vary from this method or 
ideal enough to suit special conditions. 

Banks and insurance companies for many reasons 
cannot exercise the freedom which may be enjoyed by 
many other classes of investors. For their handling of 
their funds they must constantly hold themselves ac- 
countable, not only to the rights of the public and their 
stockholders, but also to the prejudices of both. They 
must not do anything which looks like speculating, and 

(331) 



232 Sound Investing 



at the same time they may with perfect propriety buy 
bonds of speculative types, and possessing large possi- 
bilities of profit. The public likes the word "bond"; 
and while in the case of a public investigation, or an 
unavoidable embarrassment, such an institution might 
be severely criticised for investing its assets in good 
stocks, there would be no such criticism on account of 
investing them in bonds of no greater stability. 

Some of the profit-making securities, by which is 
meant securities showing definite promise of a material 
profit on the principal in addition to the interest return, 
are convertible railroad bonds, copper mining bonds, 
bank stocks, cotton mill stocks and standard preferred 
stocks. Many of these possess the dignity and reputa- 
tion necessary to justify a banking concern or insurance 
company in owning them. And it is partly a question 
of dignity and reputation; for financial institutions of 
this kind are very well able to distinguish between 
good stocks and poor, and could doubtless make larger 
profits in stock investments than in bonds, and do it 
without material sacrifice of safety. 

The Mutual Life Insurance Company, for example, 
formerly made large profits through dealing in stocks. 
It was reliably reported in 1910 that on 8,648 shares of 
Guaranty Trust Company stock it realized a net profit 
of $4,290,479. At the market prices of the first of 
January, 1910, the company's holdings of bank and 
trust company stocks were likewise reported to be worth 
$12,820,258 more than their cost. This is a large profit, 



Banks, Trust and Insurance Co.'s 233 

and it is still possible for many financial concerns, which 
are fairly free from restrictions, to make somewhat 
similar profits in bank stocks. 

Another class of profit making securities which these 
institutions may hold with propriety consists of con- 
vertible railroad bonds. In these days a bank or trust 
company not having in its service an investment expert 
is behind the times ; and for such an expert it should be 
an easy matter to distinguish between convertibles 
which are safe and promising, and those which are not. 

Probably there are not more than three or four really 
first class railroad convertible bonds, but these when 
bought in a bear market show excellent profits. They 
often decline because of the psychological influence of 
their convertibility below the prices which they are 
worth on a purely investment basis. Then when stock 
prices rise they recover accordingly; and often if 
stocks do not go high enough to give any actual value 
to the convertible privilege, the percentage of apprecia- 
tion in these bonds is much larger than in other bonds. 

Still another class of profit-making securities appro- 
priate even for conservative institutions is to be found 
in copper mining bonds. Here, however, more special 
knowledge is required than is the case with railroad 
convertibles. Besides this, the supply of copper mining 
bonds has always been small, and the supply of good 
ones is very small. Even this small supply may per- 
haps disappear unless replenished. Copper mining 
bonds do not generally stay on the market long, When 



234 Sound Investing 



the issuing company becomes a big producer, and its 
stock correspondingly rises, its bonds first enjoy a big 
rise and then are either converted or retired. How- 
ever, it is here assumed that there may be enough new 
bonds of this class issued from time to time so that the 
investor can profit in this way. Because of the great 
popularity which these bonds have had, they are not 
likely to be issued in the future on such favorable terms 
to the investor as in the past. 

Cotton mill stocks are also dignified and profitable 
investments. They have never, for many years at least, 
entered the speculative arena, even though they contain 
speculative possibilities. Special knowledge is required 
to invest in them successfully, since their annual re- 
ports are as a rule very brief, and do not give sufficient 
information upon which to base an opinion. However, 
the man familiar with the cotton mill business, with 
many of the individual mills and with the personnel of 
their managements, should be able to obtain a 5 per 
cent, secure yield upon perfectly good stocks, and to 
get enough additional profit out of the occasional rises 
in the prices of these stocks to bring the total return up 
between 7 and 9 per cent. 

Preferred railway and industrial shares may properly 
be held by banks and insurance companies which have 
the legal right to do so, if they are well selected and not 
bought in too large quantities. These yield between 5 
and 6J4 per cent, and have the added advantage of 
being pretty safe purchases a year to a year and a half 



Banks, Trust and Insurance Co/s 235 

after the beginning of a bear movement. For financial 
institutions which are free to choose, the following 
might be suggested as a reasonable diversification of 
an investment to be made during the latter part of a 
bear movement. Of course national banks issuing cir- 
culation are obliged to hold United States bonds; and 
there are many other special reasons, which there is not 
here space to discuss, why the financial institutions of 
almost every State must in practice deviate from this 
type of list. 

5 per cent, in good municipals yielding 4j4 to 5*4% 

5 per cent, in railroad equipment trusts yielding 5 to 6% 

5 per cent, in street railway bonds yielding 5 to 6%% 

5 per cent in steel and iron company bonds yielding Syi to 

6V 4 % 
15 per cent, in short term notes yielding 5j£ to 6j^% 
10 per cent, in bank or trust company stock yielding 4 to 4j^% 
20 per cent, in railroad convertibles yielding 4}i to Sy 2 % 
10 per cent, in manufacturing company bonds yielding 6 to 7% 
5 per cent, in copper mining bonds yielding 6 to 7%% 
10 per cent, in mill stocks yielding 5 to 6% 
5 per cent, in railroad preferred stocks yielding 5j4 to 654% 
5 per cent, in industrial preferred stocks yielding 6J4 to 7%% 

Of this entire list only the 10 per cent, invested in 
preferred railroad and industrial shares would be gen- 
erally considered at all speculative. However, there is 
a promise of profit on the principal in the mill stocks, 
the copper mining bonds, the railroad convertibles and 
the bank stocks. Of the total list 55 per cent. — the 
issues just enumerated — show promise of profit on the 
principal; and yet the investment as a whole is surely 
not lacking in dignity and stability. Its average yield 



236 Sound Investing 



would be 5.2 per cent, to 5.5; and it is a reasonable 
expectation that by selling the above 55 per cent, of the 
list during the next ensuing bull movement, sometime 
within two or three years, the total income might be 
brought up to about 7 or 7.5 per cent. 

It is of course contemplated that banks and insurance 
companies will shift their investments somewhat as 
business and financial conditions change. The principle 
should be to carry a large proportion of profit-making 
securities when prices are below average, and to change 
these when prices are inflated into the most stable securi- 
ties such as governments, underlying railroad and street 
railway bonds, municipals, gas and water bonds, etc. 

Several methods of determining approximately when 
to buy in the expectation of a bull movement, and when 
to sell to guard against a bear movement, are explained 
in Chapter 42. A good selection for banking and in- 
surance companies to hold through a bear movement is 
the following: 

10 per cent, in U. S. government bonds yielding 1^4 to 3% 
10 per cent, in bonds of various states yielding 4^ to 5^2% 
20 per cent, in good foreign government bonds yielding 3^4 to 

554% 
20 per cent, in best municipals yielding 4 to 4^4% 
25 per cent, in underlying railroad mortgage bonds yielding 4% 

to 4^% 
IS per cent, in railroad convertible bonds yielding 4jM$ to 5% 



XXXII 

Investments For 
Railroad, Industrial and Manufacturing 
Companies 

RAILROAD, industrial and manufacturing com- 
panies are very large investors in stocks and 
bonds, and their holdings are steadily increas- 
ing. The railroads themselves own about $5,000,000,000 
out of their own capitalization of $20,000,000,000; and 
there is a similar relation among industrial companies. 
Up to date these corporation investments have been 
made chiefly by parent companies in the stocks and 
bonds of their subsidiaries. Probably about nine-tenths 
of the railroad holdings of railroad securities are of this 
kind. The same may be said of a majority of industrial 
concerns. The Steel Corporation, for example, is noth- 
ing but a holding company, which owns almost the en- 
tire capital stocks of its numerous and great subsidiary 
concerns. 

However, nearly every prosperous railroad has its 
purely investment account made up of securities held 
for their return; and it seems more than probable that 
as time goes on, and business conditions become more 
fixed, these investment accounts will grow. Financial 
management, as a science, is in its infancy in this 

(237) 



238 Sound Investing 



country, and even within the past few years it has made 
distinct progress. The great success made by Mr. Har- 
riman with the investment account of the Union Pacific 
Railroad gave a marked stimulus to the policy of carry- 
ing large investments ; and since then the income of rail- 
roads from their investments has increased much more 
rapidly than before. 

From another point of view also it seems probable 
that there will be growth in the practice on the part of 
railroad and industrial companies of buying and holding 
good securities for their yield. That is to say, as cor- 
porations grow older there is a noticeable tendency the 
world over for them to become more conservative, and 
to try to fortify their position so that the accidents and 
misfortunes of time cannot dislodge them. This 
tendency should lead them more and more to maintain 
real reserve accounts. 

Until now the word "surplus," as used in our cor- 
poration accounting, has meant not a liquid surplus re- 
serve, but rather a surplus of the earnings of a given 
year over the necessary expenses and dividends of that 
year. It has not meant a surplus or reserve fund at all. 
When we read the words "accumulated surplus" in the 
balance sheets of one of our corporations, we naturally 
get the impression that it represents an accumulation of 
unexpended earnings which can be drawn upon at any 
time; but in fact it represents nothing of the kind. In 
truth it is not "accumulated/' but is reinvested from 
time to time in the business of the company itself — in a 



Railroad, Industrial and Mfg. Co.'s 239 

great majority of instances. With but very few ex- 
ceptions we have in this country no great accumulated 
surpluses. They are expended surpluses, which means 
that they are not surpluses at all, but have been trans- 
formed into capital assets, subject to depreciation. 

Our strongest corporations, by way of maintaining 
their financial strength, carry very large cash balances 
with the banks, but this is an expensive thing to do. 
For instance, assuming that the Steel Corporation's 
average cash balance of $55,000,000 draws only the 2 
per cent, interest usually allowed by the banks, the loss 
on it is about 3 per cent, per annum, or $1,650,000. It 
takes a rich concern to be able to carry such a luxurious 
cash balance; and the better way of doing it — viz. to 
carry less cash and more securities of the most stable 
kind — seems likely to grow in popularity. 

When securities are carried in the place of cash, it 
necessarily follows that only the most stable of bonds 
and notes should be selected. Even when they are car- 
ried not in the place of cash, but rather as a true surplus 
or reserve fund, this is almost equally true. The pur- 
pose of such a fund is to protect the given company in 
emergencies such as the panic of 1907 or the tight 
money period of 1903. At such times it is only gilt- 
edged bonds, for which there is always a ready market, 
upon which loans can invariably be obtained. 

From these considerations it follows that securities 
held as pure investments by railroad industrial and 
manufacturing corporations should be different, and 



240 Sound Investing 



should be handled differently, from those held by stock 
and bond brokers, banks, trust companies and insurance 
companies. These latter concerns are holding their 
securities for profit rather than as a cash equivalent, 
and they do not contemplate using them, except to a 
limited extent, in the capacity of reserve funds. Thus 
it is that an investment list suitable to a railroad in- 
dustrial or manufacturing company cannot be made to 
show the 7 per cent, income, which banks and trust 
companies ought to be able to earn on their securities, or 
the 8 or 9 per cent, which stock and bond dealers should 
be able to earn. Securities which are stable enough to 
be held as reserve funds do not appreciate enough to 
show any such profits. 

It is plainly inconsistent with strict conservatism for 
these companies to raise the yield on their investments 
by buying securities which will materially appreciate 
during periods of prosperity. But there are other 
methods which they may use with entire safety, and 
without introducing into their surplus or reserve fund 
any real element of risk. 

First, they may select the bonds of companies which, 
while financialy strong, have become so at a compara- 
tively recent date — that is, within a few years. The 
bonds of a concern like the Pennsylvania Railroad, 
which for decades has had a reputation for strength, 
are in great demand and therefore sell at high prices ; 
but it is quite possible to find other strong companies, 
such for example, as the Southern Pacific, the Atchison 



Railroad, Industrial and Mfg. Co/s 241 

or the Northern Pacific, whose bonds are not in such 
great demand and do not sell so high. There is a con- 
stant shifting of position among leading corporations, 
and almost every year there are some which, while pre- 
viously in a weak or mediocre financial position, become 
strong. The underlying or mortgage bonds of these 
companies are perfectly good, and have the added ad- 
vantage of yielding a quarter to three-quarters of 1 
per cent, more than those of corporations which have 
been in a fortified position a longer time. 

Second, higher yields may be obtained without loss 
of safety by giving preference to the bonds of western 
and southern corporations and municipalities. The in- 
vestor is human, and therefore he is most apt to buy 
the bond of the company which does business in his 
neighborhood, and with which he is familiar. Prob- 
ably two-thirds or three-fourths of all the investment 
capital in the United States is in the hands of persons 
east of the Mississippi Valley and north of Mason's and 
Dixon's line. These men are not so familiar with com- 
panies doing business in the west and south; and in 
consequence, the bonds of those companies are less in 
demand, and show higher yields, even where there is 
the same degree of safety. 

Third, yields may be improved by selecting from 
comparatively unpopular or unappreciated classes of se- 
curities. Prominent among these may be mentioned 
equipment trusts or car trusts; for these yield from a 
half to 1 per cent, more than other securities of equal 



242 Sound Investing 



safety. They are very high grade, are comparatively 
independent of the fluctuations of earnings, and in long 
practice have almost invariably made good, even when 
the issuing companies fell into the hands of receivers. 
Another unappreciated class of securities is to be 
found in the bonds of railroad terminal companies. 
These are usually guaranteed by one or more roads, 
and are quite stable enough to serve as a reserve fund. 
Every company naturally has its own peculiar neces- 
sities, but the following sub-division or diversification 
of an investment fund is suggested as being appropriate 
for railroad or industrial companies. This list is en- 
tirely made up of high grade stable securities, and is 
given merely as an example. The competent corpora- 
tion treasurer who is familiar with investment matters, 
would find it no difficult task to substitute other bonds 
than those here mentioned without loss of safety or 
yield. He must, however, inspect his bond in each case, 
and not allow the desire for high yield to lead him into 
any of the multitudinous bonds which, although not 
really very stable or safe, are nevertheless very highly 
recommended. 

5 per cent, in United States bonds yielding about 2 to 3$&% 
5 per cent, in foreign government bonds yielding 4 to 6%% 
5 per cent, in State bonds yielding 3^4 to 4j4% 
15 per cent, in western municipals yielding Ay 2 to 5^2% 
10 per cent, in railroad mortgages yielding 4$$ to 5$i% 
20 per cent, in equipment trusts yielding 5 to 6% 
10 per cent, in electric railway underlying mortgages yielding 

4J4 to 6% 
15 per cent, in short term notes yielding 5^ to 6$£% 
5 per cent, in terminal company bonds yielding 4$i to 5j£% 
5 per cent, in gas and electric light bonds yielding 4% to 5%% 
5 per cent, in water company bonds yielding 5 to Wa% 



Railroad, Industrial and Mfg. Co.'s 243 

It would not of course be good policy for a corpora- 
tion treasury to attempt to increase its total investment 
income by shifting or changing its securities as de- 
scribed in the previous Chapter. This is true not only 
because the typical corporation managements are very 
bad judges of the stock and bond markets, but also be- 
cause such shifting, if done to any large extent, might 
defeat the very purpose of the reserve fund. How- 
ever, a moderate amount of changing in these invest- 
ments could be made in accordance with the time, so as 
to increase the average yield by probably about 1 per 
cent. 

When security prices are inflated — which time one 
may determine as described in Chapter 42, — a corpora- 
tion may wisely sell its short term notes, gas and electric 
light company bonds and water company bonds, and 
handle the proceeds in either of two ways. In times 
of such inflation interest rates are always high, and the 
funds can be loaned in the money market to show a 
return of 5 or 6 per cent., or they can be reinvested in 
such securities as are mentioned at the end of Chapter 
31. Either method serves to prevent depreciation of the 
investment account during the ensuing bear movement 
and to increase the total average yield. 

Then, as the bear movement draws to a close, there 
are also two ways in which the total yield may be fur- 
ther increased. At such times the typical corporation, 
having greatly reduced its bills receivable, has on hand 
a lot of idle cash. This ordinarily goes into the banks, 



244 Sound Investing 



where it draws either 2 per cent, or else nothing at all, 
and serves no useful purpose. There it awaits the re- 
sumption of business activity, which after a panic or 
great bear movement, is a year or thereabouts. Now, 
during this year the idle money could with entire 
conservatism be invested temporarily in such securities 
as are mentioned in the foregoing list. Furthermore, 
at such times the short term notes, gas and electric 
light bond and water company bonds can again be taken 
on at lower prices. 

By these methods and without any expert knowledge 
of security markets, the ordinary railroad, industrial or 
manufacturing concern can obtain an average income 
of Sy 2 to 6 per cent., while at the same time maintain- 
ing a general reserve fund which, under some occasional 
financial and industrial conditions, is sure to be 
enormously valuable. 



XXXIII 

Investments For 
Trustees and Estates 

NO class of investors is much more important in 
any respect than estates and trustees. Neither 
is there any class of investors who encounter 
much more difficulty. The regulations of the various 
states so hamper them in their operations that they are 
under the constant temptation to sacrifice yield to safety, 
or else sacrifice safety to yield. They are under the di- 
rection of laws which are largely unintelligent and of 
courts, many of which have little or no expert knowl- 
edge of investments. Besides this, they are constantly 
tempted to select non-taxable issues in preference to 
other securities which are really safer; and during the 
past few years many an estate, especially in Massachu- 
setts, has lost money through yielding to this tempta- 
tion. 

In this short chapter it is neither possible nor de- 
sirable to observe, except in the most general way, what 
are the duties of trustees in making investments. How- 
ever, a few of the most fundamental may be mentioned. 
First, when the property is once well invested, the in- 
vestment should remain unchanged except where there 
are good reasons for making changes, such as a loss of 

(245) 



246 Sound Investing 



security or yield. A rise in the price of a stock or bond, 
unless it be to speculative heights, is hardly a sufficient 
reason. Second, it is the duty of trustees not only to 
invest the funds safely, but also to so handle them as 
to obtain the current rate of interest. Third, it is their 
duty to comply strictly with the terms of the trust, and 
generally with the principles of investment laid down 
by the Legislature and the courts of their States. 

Where the highest courts have not determined in what 
securities a trustee may invest, the safe method is to 
follow the savings bank laws; but in doing so judgment 
should be exercised, since it not infrequently happens 
that a corporation of great influence induces a legisla- 
ture to make some of its securities legal for saving 
banks, even though they are not particularly secure. 

Legislatures have made a great variety of rules cover- 
ing these investments; but these rules are not binding 
upon a trustee who under the trust instrument receives 
special powers exceeding the rules. It has been a 
rather general practice for these instruments to give the 
trustee the larger discretion allowed by the so-called 
"Massachusetts rule"; and what this rule is may be seen 
from the following quotation from Chief Justice Field: 

"A trustee whose duty it is to keep the trust fund 
safely invested in productive property, ought not to 
hazard the safety of the fund under any temptation to 

make extraordinary profits Our cases, however, 

show that trustees in this Commonwealth are permitted 
to invest portions of trust funds in dividend-paying 



Trustees and Estates 247 

stocks and interest-bearing bonds of private business 
corporations, when the corporations have acquired, by 
reason of the amount of their property and the prudent 
management of their affairs, such a reputation that cau- 
tious and intelligent persons commonly invest their own 
money in such stocks and bonds as permanent invest- 
ments." 

The New York rule up to a very recent date, at least, 
was very narrow, practically forbidding trustees to in- 
vest in the stocks of railroads, banks, or manufacturing 
or insurance companies. On the other hand, the above 
Massachusetts rule is very broad, and gives to the trus- 
tee with an expert knowledge of investments practically 
all the latitude he needs in handling the account. His 
principal temptation is to select non-taxables, which are 
not necessarily secure. Neither has he any chance to 
evade the tax, even where there is double taxation so 
plainly unjust that the most conscientious would gladly 
do so. 

Investments of an untried or speculative nature are 
disapproved in all the States. So, too, are loans on 
personal securities, investments in unincorporated con- 
cerns, in patent rights, in second mortgages, and in all 
unproductive ventures. As to the regulations of the 
various States, the following brief abstract taken prin- 
cipally from the Trustees Handbook by Mr. August P. 
Loring may be of service. At least it tends to show in 
what respect the trustee must vary from the investment 
selection made hereafter. 



248 Sound Investing 



Alabama permits trustees to invest only in securities 
of the United States and the various States, but not in 
those of private corporations. For Alaska, Arizona and 
Arkansas there are no authorities. In California the 
so-called "American rule" prevails; and this is that "a 
trustee must observe how men of prudence, discretion 
and intelligence manage their own affairs, not in regard 
to speculation, but in regard to the permanent disposi- 
tion of their funds, considering the probable income, 
as well as the probable safety of the capital to be in- 
vested." 

In Colorado they may invest in bonds of the United 
States or Colorado, but not in the securities of private 
corporations; Connecticut permits them to invest in 
savings bank securities and holds them rigidly respon- 
sible for funds placed in other securities. In Delaware 
the Massachusetts rule prevails. In Florida the rule is 
United States and State securities and bank stocks; and 
in Georgia it is State securities and other investments 
made under court orders. For Hawaii and Idaho there 
are no authorities ; and in Illinois the Massachusetts rule 
prevails. In Indiana the courts have upheld the Massa- 
chusetts rule, but also the New York rule; and in Iowa 
the United States and State securities are approved. 
For Kansas there are no authorities. 

Kentucky permits investments in mortgages, stocks 
and bonds, but not in railroads unless operated ten 
years without defaulting, or in municipal securities un- 
less the municipality has gone ten years without de- 



Trustees and Estates 249 

faulting. For Louisiana there are no authorities ; and 
in Maine it is the Massachusetts rule. Maryland ap- 
proves State securities and those advised by the court; 
and in Michigan the Massachusetts rule pervails. Min- 
nesota requires the trustee to obtain court directions. 
The Massachusetts rule prevails in Mississippi and Mis- 
souri; and Montana specifies that the trustee shall seek 
to obtain a reasonable security and reasonable interest. 
For Nebraska and Nevada there are no authorities. 

New Hampshire permits investments in savings bank 
securities, municipals, United States securities, and in 
the stocks and bonds of railroads whose rentals are 
guaranteed by the Boston and Maine, New Haven or 
the New York Central. In New Jersey the rule is the 
bonds of the United States or New Jersey, or certain 
municipalities and also savings bank securities. There 
is no authority for New Mexico. United States and 
State bonds, and the Massachusetts rule prevail in North 
Carolina; and in North Dakota the American rule pre- 
vails. In Ohio trustees must get court approval for in- 
vestments other than United States or State securities. 
For Oregon there are no authorities. 

Pennsylvania does not permit investment in securities 
of business corporations, but does permit those in United 
States, State or municipal bonds, and in the bonds of 
school districts, or in real estate bonds. In Rhode Island 
it is Massachusetts rule, as it is also in South Carolina. 
In South Dakota the rule is reasonable security and 
reasonable interest; and in Tennessee trustees must re- 



250 Sound Investing 



port to the county court investments in securities other 
than those of the United States. Texas follows the 
Massachusetts rule, and for Utah there are no authori- 
ties. In Vermont court directions must be obtained, and 
the Massachusetts rule generally prevails. The same 
rule prevails for Virginia and Washington. In West 
Virginia, United States and State securities are the rule. 
Wisconsin permits investments in municipals, govern- 
ments, and in the securities of railroads which have paid 
dividends for ten years on their entire capital, and also 
on real estate securities. For Wyoming there are no 
authorities. 

In view of these general restrictions the following 
general suggestion is made. For those living in States 
where the Massachusetts rule prevails, it can be fol- 
lowed almost literally, while in many other States it can 
be taken with the approval of the courts; but in other 
States great modification may have to be made unless 
the trust instrument confers sufficiently wide powers. 

S per cent, in United States bonds yielding about 2 to 3$i% 
5 per cent, in foreign government bonds yielding 4 to 6%% 
5 per cent, in State bonds yielding 354 to 4j^% 
5 per cent, in municipals yielding A 1 /^ to Sy 2 % 
25 per cent, in railroad equipment trusts yielding 5 to 6% 
10 per cent, in railroad convertible bonds yielding AY% to Sj4% 
25 per cent, in short term notes yielding 5^ to 6^4% 
10 per cent, in public utility bonds yielding 4% to 6$^% 
10 per cent, in industrial convertible bonds yielding 4j^ to 5j^% 

As to this subdivision or diversification, its adaptation 
to the needs of trustees consists in its fair yield, its pos- 
sibilities of profit, its practical certainty of winning court 



Trustees and Estates 251 

approval in States where the Massachusetts rule prevails, 
and in the frequency with which it permits the trustee 
to reinvest large portions of the fund. Where long term 
bonds are taken he seldom has opportunity to reinvest 
and thereby enhance the yield. Good yields can hardly 
be obtained without constantly reinvesting in accord- 
ance with changes in business conditions and in the po- 
sition of the security markets; and yet the desire to 
obtain a larger yield would hardly be regarded in court 
as a sufficient reason for selling long term bonds. 

Hence it is a decided advantage that in the list sug- 
gested, 25 per cent, consists of equipment trusts matur- 
ing at near-by dates, while another 25 per cent, is made 
up of corporation notes also having short maturities. 
Furthermore 10 per cent, is in railroad convertibles. 
These are good, and in bull markets they sell at high 
speculative prices ; and that very inflation of price would 
be a sufficient reason for selling and thereby obtaining a 
profit on the principal for the beneficiary. In like 
manner 10 per cent, consists of industrial convertibles, 
of which the same holds true. Of the entire list the 
trustee within a short time would have the opportunity 
to reinvest about 70 per cent, in accordance with changed 
conditions. 

The United States bonds serve very well as "window 
dressing"; the foreign governments, municipals and 
State bonds will serve the same purpose. All these, if 
properly selected, are very high grade, and can be held 
through thick and thin without any danger of material 



252 Sound Investing 



depreciation in price. Furthermore, the trustee, without 
getting into trouble, can really often take advantage of 
a bear movement in security prices. If, for example, he 
finds by study of the indications described in Chapter 
42, that a bear movement is presumably about ended, he 
can reinvest a large portion of this fund. Fifty per cent, 
of the total fund always represents short maturities, and 
besides this amongst the other 50 per cent, there are 
bound to be quite a number of bonds close to maturity. 
As any of these bonds approach maturity, they are prac- 
tically certain to sell so close to par that they can 
properly be sold even a few months before they mature. 
Such a policy gives the trustee a chance to reinvest at 
a time when bonds are cheap. 

Furthermore, the 20 per cent, invested in convertibles 
and the 10 per cent, invested in public utility bonds are 
very likely, during a bull movement, to sell at prices above 
their intrinsic values. If the trustee finds that under the 
laws and court rulings of his State this would be a suffi- 
cient reason for selling them then around the top of a 
bull movement, he has an opportunity to sell and invest 
the proceeds in short term equipment trusts or other 
notes running about a year or a year and a half. As this 
is the approximate duration of an ordinary bear move- 
ment such notes would mature just at the time when 
he would later on wish to reinvest at bargain prices. By 
these methods, at least in some States, the yield can be 
brought up to 5*4 to Sy 2 per cent., whereas without 
such close attention a yield of Ay 2 per cent, is about all 
that could safely be obtained. 



XXXIV 

Investments For 
Colleges, Hospitals and Other Institutions 

THERE was a time when any business man of 
sound sense was a capable manager of invest- 
ments, but that time has passed. There was also 
a time when every man built his own hut to live in, but 
now we employ architects, builders and landscape gar- 
deners. Even in quite recent years manufacturers de- 
signed and built their own mills, but now the mill archi- 
tect has an established place. Times have changed, and 
with them the matter of handling investments, instead 
of being a small part of the common knowledge which 
every business man is supposed to possess, has become 
a subject of specialized study and expert management. 

Our colleges and institutions, however, have very 
generally adhered to the old idea that any good business 
man was a good investor. Indeed, seats of learning in 
this and all times have been bulwarks of conservatism 
and defenders of the old against the new. Inventors 
and reformers in the science of investment, as in all 
other fields, have been generally ridiculed, scorned or 
opposed. Some generations ago we used to call the ad- 
vocate of a new idea (whether it was religious or scien- 
tific), a heretic, and excommunicate him, or possibly burn 

(253) 



254 Sound Investing 



him at the stake; but now the tables have been turned. 
Whereas the man of new ideas used to be the punished, 
he is now the punisher. In every one of our big indus- 
tries those who refuse to adopt new ideas are being 
punished through the deadly competition which progres- 
sive men are giving them. 

A few of our leading universities have developed the 
study of economics to such a point as to make it of prac- 
tical value, not only to the learning public, but also to 
the institutions themselves. While mental culture un- 
doubtedly should remain the primary aim of these in- 
stitutions of learning, practical finance is intricate 
enough in both theory and application to give even the 
best brains all the mental gymnastics they may require. 
In particular the science of investments seems bound 
to receive more and more attention from the economic 
departments of colleges and universities, because it has 
grown so rapidly in importance to the public. The 
corporate form of ownership, especially during the past 
fifteen years, has made vast strides and is still doing 
so. With the spread of this form, ability to analyze 
stock and bond values has become correspondingly 
more important to every endowed institution. 

From now on the college whose board of overseers 
or trustees is progressive in the scientific management 
of its investments is likely to punish the one whose board 
is not progressive by a similar sort of competition to 
that which has been experienced in business life. The 
success which a college or university can accomplish 



Colleges, Hospitals and Institutions 255 

depends much upon its yearly income, and that in turn 
depends considerably upon efficient and scientific man- 
agement of its investments. These are some of the 
reasons for believing that the subject will be given more 
attention in the future than in the past. 

As an illustration of the moderate yield sometimes 
obtained by these institutions, even where a fair degree 
of risk has been assumed, the following is a summary 
of the securities held a few years ago by one of the 
leading universities: 

Security — Investment Income Yield 

Mortgages and notes $1,310,000 $71,610 5.47% 

Municipals and governments 108,584 4,727 4.35 

Railroad bonds 5,147,000 211,575 4.11 

Street railway bonds 1,584,641 68,405 4.32 

Other bonds 2,340,487 105,760 4.52 

Railroad stocks 1,121,817 55,454 4.93 

MTg and Telephone stocks .... 473,062 25,574 5.41 

Real estate stocks 695,421 25,936 3.73 

Other stocks 132,107 6,000 4.54 

$12,913,119 $575,041 4.45% 

More than 18.7 per cent, of this entire investment in 
securities was placed in stocks; and among these were 
found considerable amounts of New Haven, Chicago 
and St. Paul, New York Central, and other issues which, 
since the date of the above statement of holdings, have 
suffered from reduced dividends and bad breaks. In 
brief, the security list was not one of exceptional sta- 
bility, and yet its yield was only 4.45 per cent. The 
very farthest thing from my intention is to criticise the 
management of any particular institution, and the sole 



256 Sound Investing 

purpose of this illustration is to point out that through 
a closer sudy of investments better results can be ob- 
tained. A list showing a yield of only 4.45 per cent, 
should have shown a degree of stability which this one 
did not possess. 

As these institutions are accountable to no one except 
themselves and their patrons, their handling of their 
investments is less hampered by arbitrary restrictions 
than is the case with estates. They cannot of course 
afford to speculate in any sense of the term; but at 
the same time they can shift their investments from 
time to time in accordance with changes in business 
conditions, and in the position of the stock and bond 
markets. This very shifting — into securities which will 
appreciate when the market is low, and into those which 
will not depreciate when the market is high — should 
materially enhance their income. 

Besides this, many additional thousands can be saved 
by selecting carefully within each class of securities. 
A comparatively unknown bond sells lower and yields 
more than a bond of equal quality which is known ; 
western securities, since the average rate of interest is 
higher in the west, generally yield more than eastern 
securities of equal quality; bonds which are secured by 
a very wide margin of safety usually yield more than 
others which, while no more stable, are secured by a 
larger percentage of physical property, or by more rigid 
legal restrictions; and the bonds of small companies 
often yield more than those of larger and better known 
concerns. The following suggestion may be offered: 



Colleges, Hospitals and Institutions 257 

15 per cent, in railroad equipment trusts yielding 5 to 6% 

15 per cent, in street railway bonds yielding 5 to 6%i% 

10 per cent, in railroad common stocks yielding 6J4 to 7%% 

15 per cent, in short term notes yielding 5^ to 6J4% 

15 per cent, in convertible bonds yielding 4*4 to 5^4% 

15 per cent, in manufacturing company bonds yielding 6 to 7% 

15 per cent, in preferred stocks yielding 5j/2 to 7Y^% 

A list carefully made up in this manner should show 
at least as great stability as the actual list mentioned 
above, and should yield a full one per cent, more on the 
entire investment. If this be true, it means that the 
difference in income between handling the investment 
through an expert study, and handling it in the old 
fashioned manner, is about 22 per cent. Street railway 
bonds are highly desirable because many of the com- 
panies operate in sections where the average price of 
capital is high, and are not big enough to finance them- 
selves with low-cost capital in the big financial centers. 

Short term notes must be selected with a constant 
eye upon the earnings and strength of the issuing cor- 
poration. Convertible bonds are attractive only when 
stock and bond prices are below average, so that the 
convertibles show a fair yield plus a definite promise 
of a profit on the principal. The attractiveness of manu- 
facturing company bonds lies in the high yield which 
may be obtained through careful selection. In buying 
preferred stocks great care must be used to avoid those 
which are sadly watered, and with such care, yields close 
to 6 per cent., together with a high degree of safety, 
and with a promise of profit on the principal, may be 
obtained. 



258 Sound Investing 



Such a list as this is surely not lacking in stability, 
and yet if carefully selected when the market is low, 
it would show an average yield of Sy 2 to 6 per cent. 
Furthermore, if a reasonable profit on the convertible 
bonds and preferred and common stocks were realized, 
the yield could be further raised to some figure between 
6% to 6}i per cent. When prices become substantially 
higher than the average or when the factors mentioned 
in Chapter 42 indicate that a bull movement is drawing 
to a close, the investment may wisely be shifted into 
such securities as the following to be held for a period 
lasting up to and including the next bear movement. 

15 per cent, in U. S. Government bonds yielding 1^4 to 3% 
20 per cent, in bonds of various states yielding 3^4 to 4j4% 
15 per cent, in foreign government bonds yielding 3^4 to S%% 
25 per cent, in good municipals yielding 4 to 4^4% 
15 per cent, in the best railroad mortgage bonds yielding 4% 

to Ay 4 % 

10 per cent in equipment trusts yielding 4H to 5% 



XXXV 

Investments For 
Business Proprietors and Partners 

FINANCIAL papers frequently give lists of bonds 
suitable for "business men", but there are all 
sorts of business men. The man at the head 
of a concern properly comes under this heading, and 
so do the clerks, bookkeepers and salesmen. All of 
these men do business of their kind, but it is only those 
at the top who have had the experience and training 
of judgment which fit them to pass upon the merits and 
demerits of various classes of securities. Hence it is 
that the title of this Chapter is quite specific. 

The same training which enables a man to rise to the 
head of a firm, or to fill the position if inherited, should 
enable him with a little additional study to distinguish 
clearly between good, doubtful and poor securities. 
Special training of judgment is as necessary in handling 
investments as it is in law, medicine or engineering; 
and the man who has it may safely buy certain classes 
of securities which to the man who does not have it 
would result in almost certain loss. For instance, there 
are all sorts of corporation notes; and a successful busi- 
ness man is so thoroughly familiar with the earmarks 
of sound management that he can select the wheat from 

(259) 



260 Sound Investing 



the chaff, and buy on breaks perfectly safe corporation 
notes which will yield him about 6 to 6^4 per cent. 

Yield is partly a question of training and experi- 
ence; and the more of these the investor has the higher 
is the average yield which he can obtain without jeop- 
ardizing his capital. Next to stock and bond brokers 
and bankers the proprietors and partners of business 
concerns ought usually to be the most expert judges of 
values. They should, therefore, be able to obtain a yield 
beyond the reach of persons of less experience. Invest- 
ment opportunities are greatly diversified as compared 
with what they were a few years ago, so that men of 
this class or caliber should, during bull markets, be able 
to net 7 or 8 per cent. 

It is here suggested that 15 per cent, of the total in- 
vestment be put in high grade gas company, street rail- 
way and steel and iron bonds. This sixth of the total 
placed in such stable securities would materially increase 
the stability of the total investment, and prove very re- 
assuring in case of unexpected happenings. However, 
it is not intended that only 15 per cent, should be securi- 
ties of high stability, for business men of this type 
should be able to choose corporation notes and convert- 
ible bonds which while showing a good return will also 
prove decidedly stable. Hence the dependable and very 
stable type of bonds should constitute not merely 15 per 
cent., but rather about 50 per cent, of the total list. 

High grade is not the only advantage of corporation 
notes, for these mature at near-by dates, thus giving 



Business Proprietors and Partners 261 

occasion to reinvest the money; and for the man cap- 
able of doing this wisely it is desirable to shift his list 
from time to time in accordance with changing condi- 
tions. Such notes, moreover, are excellent collateral for 
loans, and 15 per cent, of the total investment may well 
be placed in them. Neither is there any lack of oppor- 
tunity for the exercise of judgment in the selection of 
convertible bonds, both railroad and other; for out of 
all the convertible bonds usually quoted, probably in 
half or two-thirds the convertible privilege will never 
be worth anything. Hence in selecting, the investor will 
choose a convertible which is fairly well secured and 
shows a reasonable yield. Besides this, to satisfy him 
it must be convertible into a stock having enough in- 
trinsic merit and earning power to give definite promise 
that its price will so rise as to enhance the value of 
the convertible privilege. 

Manufacturing company bonds are attractive because 
of their high yield; and here too, trained judgment plays 
a most important part. There is no kind of business 
which can make so much money on the one hand, or 
collapse so completely on the other, as a manufacturing 
business. The assets of a railroad are worth something, 
whether the company is earning money or not, because 
in any event some other railroad can take them and 
use them profitably, but the assets of a manufacturing 
plant depend almost wholly for their value upon their 
earning power. If the company isn't making money it 
has no right of way, or other monopoly element, to 



262 Sound Investing 



give it value; and its assets, practically speaking, are 
junk. 

For many reasons the investor in selecting manufac- 
turing company bonds will entirely avoid those which 
are in the prospective stage, and will give preference 
to those of companies which show good earnings not 
for one year only, but for a series of years. If a manu- 
facturing concern does not earn two to five times its 
fixed charges over and above maintenance and depre- 
ciation, its bonds hardly appear attractive. 

Still more is judgment required in selecting stocks. 
There are all sorts of preferred industrials which are 
highly recommended by old investment houses; but ex- 
perience indicates that the successful business man who 
trusts to his own judgment will fare better in the end 
than the one who acts upon advice. The principal point 
to remember is that stocks are not promises to pay, but 
are merely probabilities of profit. In practice a board 
of directors may discontinue dividends almost any time, 
and the stockholder can seldom enforce in the courts 
any claims that dividends are due him. To own a stock 
is to own a share in the net profits of the given concern, 
over and above its fixed charges; and there is nothing 
like experience to determine how valuable such a share 
in net profits may be. Generally speaking, it is there- 
fore desirable to avoid investing in the stocks of new 
concerns. As speculations they may be excellent, but 
that does not prove that they are suitable for the man 
who wants a fairly sure return on his money. 



Business Proprietors and Partners 263 

Having in mind these considerations it is suggested 
that business proprietors and partners subdivide their 
total investment in some such manner as the following: 

5 per cent, in gas company bonds yielding 4% to 5%% 
5 per cent, in street railway bonds yielding 5 to 6$^% 
5 per cent, in steel and iron bonds yielding S 1 /^ to 6^4% 
15 per cent, in corporation notes yielding 5^ to 6j4% 
10 per cent, in railroad junior bonds yielding 4J4 to 6Y 2 % 
20 per cent, in convertible bonds yielding 4^ to Sy 2 % 
15 per cent, in manufacturing company bonds yielding 6 to 7% 
5 per cent, in copper mining bonds yielding 6 to 7^4% 
10 per cent, in industrial preferred stocks yielding 6^4 to 7%% 
5 per cent, in railway common stock yielding 6J4 to 7}4% 
5 per cent, in copper stocks yielding 6^2 to S%% 

A list of this type bought during the latter part of a 
bear movement should yield between 5 $4 and 6% per 
cent, on its actual cost. In it the only securities which 
need not be expected to show a profit on the principal 
are the 15 per cent, invested in high grade bonds of gas 
companies, street railways and iron and steel companies. 
Naturally the profits on the corporation notes will be 
small, but there should be some profit. The convertible 
bonds in the course of a bull movement ought to yield 
several points profit, and the manufacturing bonds 
should show almost as much appreciation, together with 
a higher current yield. The copper mining bonds, as- 
suming that good ones may be available, should show 
a big profit; and an average rise of 10 to 20 points, 
varying according to the extent of the bull movement, is 
not improbable. After the upward movement has seem- 
ingly about spent itself it should prove advantageous to 



264 Sound Investing 



dispose of almost the entire list of these investments, 
and change into the following — only to repeat the opera- 
tion during the next bull movement. 

20 per cent, in bonds of various states yielding 3^4 to 4j^% 
15 per cent, in foreign government bonds yielding 3^4 to 5j4% 
25 per cent, in municipals yielding 4 to 4^4% 
15 per cent, in best railroad mortgage bonds yielding 4j^ to 

43/4% 
15 per cent, in very best short term notes yielding 4^4 to 5% 
10 per cent, in equipment trusts yielding 4ty& to 5% 



XXXVI 

Investments For Professional Men 

WITHIN this class of investors must be included 
lawyers, doctors, teachers, writers, ministers, 
scientists, and all sorts of professional men. 
Of course no investment suggestion could exactly fit all 
these men. There are, for example, a great many 
corporation lawyers whose experience thoroughly fits 
them to judge securities in an expert manner; and these 
can afford to change their investments oftener and buy 
a larger percentage of securities showing a lower degree 
of safety and a higher yield. However, the investment 
needs of professional men, as a class, undoubtedly call 
for securities of a high degree of safety, and a fair yield. 
The doctor, lawyer or teacher who makes any sort of 
a success must do a huge amount of brain work, and 
after the accomplishment of his duties, he has left neither 
the time nor the mental energy for the study of the 
intricacies of finance. Medicine, for example, is one 
profession and finance is quite another. To mix the 
two might be very harmful to both. High yields must 
be obtained principally by a continual shifting of invest- 
ments made in accordance with current changes in finan- 
cial conditions and in the position of the security mar- 
kets. Such shifting can be done only by those who give 
constant attention to finance and securities; and profes- 

( 265 ) 



266 Sound Investing 



sional men, because of the very nature of their work, 
cannot do this. 

In the suggestion here made it is therefore contem- 
plated that the investor will give attention only occasion- 
ally to his list of securities, and that these occasions will 
be rather accidental, depending upon when the particular 
individual happens to have leisure time. They will 
doubtless be quite independent of the particular dates 
upon which significant changes occur in the stock and 
bond markets. Hence the securities purchased must be 
of the kind which do not require constant watching. 
They must not be speculative securities, because no pro- 
fessional man can succeed with one eye constantly on 
the stock market. 

Nevertheless, men of this class should be able to shift 
their investments often enough to materially enhance the 
yield. That is to say, when prices are generally below 
intrinsic values, and also below average, a considerable 
part of the investment should be put into good stocks 
and convertible bonds in order to get the advantage of 
the succeeding recovery. Prices never remain long just 
at the level of intrinsic values. Depressions or political 
changes cause them to go below, whereas booms in busi- 
ness cause them to rise above values. Hence they con- 
stantly cross and recross the value line and never stay 
upon it long. The speculative way to take advantage of 
this unending movement is to buy and sell on margin, 
but the conservative investment way is to buy outright 
a few of the best stocks and convertible bonds when 



Professional Men 267 

prices are low, and sell them all out when the stock mar- 
ket is booming. In pursuance of this plan the following 
suggestion is made: 

5 per cent, in foreign government bonds yielding 4 to 6J4% 
5 per cent, in municipals yielding 4 T A\ to S]/ 2 % 
5 per cent, in gas and electric bonds yielding 4% to S%% 
5 per cent, in street railway bonds yielding 5 to 6$^% 
10 per cent, in railway equipment trusts yielding 5 to 6% 
10 per cent, in convertible bonds yielding 4}i to SYiJo 
5 per cent, in steel and iron company bonds yielding 5# to 

10 per cent, in manufacturing company bonds yielding 6 to 7% 
5 per cent, in copper mining bonds yielding 6 to 7^4% 
15 per cent, in short term notes yielding 5fy& to 6^4% 
15 per cent, in railroad preferred stocks yielding S T A to 6j^% 
5 per cent, in industrial preferred stocks yielding 6% to 7^4% 
5 per cent ia railroad common stocks yielding 6J4 to 7%% 

An investment carefully made up in this way should 
show an average yield, including therein the profit on 
the principal, of 6^ to 7% per cent, during a bull move- 
ment. This is of course upon the condition that the 
securities be bought during the latter part of a bear 
movement, or the very early part of the succeeding bull 
movement. The manner of determining the time to 
make the purchase, and of doing so upon the basis of 
scientific economic principles rather than mere guess 
work is described in Chapter 42. At such times the 
investor need not hesitate to purchase securities show- 
ing yields of more than 6 per cent., even though such 
high yields in normal times would be an indication of 
poor quality. But at the same time in buying these high 
yield securities, the financial reports of the issuing com- 



268 Sound Investing 



panies should be examined as described in preceding 
chapters to determine whether the given companies are 
in good condition. 

When a general rise in securities has proceeded for a 
period of one to three years, and financial conditions are 
such as to foreshadow a bear movement, the above list 
should be entirely revised. It is of course impossible 
and unnecessary to select the exact moment when a gen- 
eral decline is going to occur. Ordinarily if the investor 
gets within six months of the right time he is doing quite 
well enough for all practical purposes. An investment 
to hold throughout the bear movement may well be made 
up as follows: 

IS per cent, in U. S. government bonds yielding 154 to 3% 
20 per cent, in bonds of various states yielding 3^4 to 4j^% 
IS per cent, in foreign government bonds yielding 3^4 to 5$i% 
25 per cent, in good municipals yielding 4 to 4J4% 
15 per cent, in best railroad mortgage bonds yielding 4% to 

10 per cent in equipment trusts yielding 4}i to 5% 



XXXVII 

Investments For Salaried People 

IF this term were stretched to its widest significance, 
it would include the hundred thousand dollar presi- 
dents of railroads, banks and other corporations; 
but it is here intended to include only the classes com- 
monly spoken of as salaried people. The particular class 
here referred to consists of course of those receiving 
yearly salaries of about $4,000 or less; for those receiv- 
ing more than this, as a usual thing, have acquired an 
amount of business experience and skill in judging 
values which should enable them to manage their in- 
vestments in ways such as were suggested for business 
proprietors and partners. 

Manifestly the chief difference between these two 
classes of investors is the difference in business experi- 
ence and training. Moreover, as a rule the smaller the 
amount to be invested the more anxious is its owner to 
obtain a high rate of income, and the greater is the risk 
he assumes. This disposition to assume risks is some- 
times due to inexperience, and sometimes to a feeling 
that the assumption of rather speculative risks offers the 
only hope of escape from poor circumstances. What- 
ever the reason, it is surely true that an investment 
suggestion which did not afford at least a chance of 
large profits would fall flat with a very large proportion 
of salaried people. 

(269) 



270 Sound Investing 



The task of making such a suggestion is on this ac- 
count a difficult one. What is wanted is a method of 
doing a radical thing conservatively; and while this of 
course is impossible, there is here suggested about the 
safest possible way of obtaining a fair yield, together 
with a chance for large profits. In the suggestion for 
business proprietors and partners the securities advised 
throughout almost the entire list were those which in- 
volved some slight risk, and required the exercise in 
their selection of unusually good judgment. Salaried 
people, however, do not have the training necessary to 
develop the judgment to such a high point; and there- 
fore a different method of selection has to be followed. 

Hence the method here offered is to put by far the 
greater part, say about 80 per cent., of the total invest- 
ment into absolutely safe bonds and notes which should 
make good in almost any sort of a market. In this way 
the possibilities of loss are greatly reduced, and an as- 
sured income which will average 4^4 to 5^ on the 
total investment may be obtained. Then to obtain the 
chance of large profits it is suggested that the other 20 
per cent, be placed in stocks, which, while promising in 
themselves, are nevertheless of a more speculative type. 
By this method it is sought to reduce the risk absolutely 
to 20 per cent. In practice it would be reduced lower 
than that because the stocks, even if they should show 
a loss, would probably not show a greater loss than 25 
or 50 per cent, of their cost prices. For this reason the 
risk on the total investment should practically be down 



Salaried People 271 

in the neighborhood of 10 per cent. The suggestion is 
as follows: 

10 per cent in municipals bonds yielding Ay 2 to S T A% 
10 per cent, in foreign governments yielding 4 to 6^4% 

5 per cent, in gas and electric light bonds yielding 4^ to $Y%% 
10 per cent, in railway equipment trusts yielding 5 to 6% 
10 per cent, in convertible bonds yielding 4^ to 5^2% 
10 per cent, in steel and iron company bonds yielding 5J4 to 

6J4% 
10 per cent, in manufacturing company bonds yielding 6 to 7% 

5 per cent, in railroad mortgage bonds yielding 4^ to 5j^% 
10 per cent, in short term notes yielding 5^ to 6^4% 

5 per cent, in railroad common stocks yielding zero to 7% 

5 per cent, in industrial common stocks yielding zero to 8% 
10 per cent, in copper stocks yielding zero to 10% 

Where the sum is small it is of course impossible to 
follow this suggestion literally. However, a great many 
good bonds in denominations of one hundred dollars to 
five hundred dollars can be found. Where the sum is 
too small to cover this diversified list, even with low 
denomination bonds, then the general principle may be 
followed by putting 80 per cent, of the total into good 
bonds such as suggested, and putting the balance into 
stocks. 

The object of putting 20 per cent, into the more specu- 
lative stocks, such as non-dividend paying rails and low 
priced industrials and coppers, is to obtain the largest 
possibility of profit with the smallest risk. In bull mar- 
kets stocks of this class appreciate fully twice as much 
as standard dividend-paying railroad shares or preferred 
industrial shares. For instance, from the low point of 
1903 to the high point of 1906 twenty-one standard rails 



272 Sound Investing 



appreciated 61.3 per cent., while twenty-seven rails 
which paid no dividends in 1903 appreciated 136.9 per 
cent. ; and twenty rails which paid no dividends in 1903 
or 1906 rose 131.1 per cent. 

Salaried people, as a class, are the victims of every 
fake mining scheme, and of almost every other stock- 
selling scheme. They are visited and circularized by the 
agents of crooked concerns, and thousands of them every 
year are induced to put their money into absolutely 
worthless stocks. Other thousands, after watching a 
bull market in Wall Street for a year or two, finally 
become enthusiastic and buy some low-priced shares on 
the theory that in the next ensuing two years said shares 
will go up as much as certain other stocks have in the 
past two years. At the top of a bull market one con- 
tinually hears this kind of reasoning. The theory is all 
wrong, because low-priced shares at such times, instead 
of being cheap, are the dearest of all. At the top of a 
bull movement anything which has any value at all is 
not low-priced; and the shares which are low-priced are 
so because they are almost worthless. Bearing these 
facts in mind those who have not had time to make an 
extended study of investments themselves will find the 
following to be good practical rules for avoiding losses. 

(1) Never buy stocks of agents or solicitors unless 
they represent bond houses which have a good rating in 
Dun's or Bradstreet's. 

(2) Confine your purchases principally to securities 
quoted in the markets of New York, Chicago, Boston 
and Philadelphia. 



Salaried People 273 



(3) Let the securities of bankrupt companies, or con- 
cerns in receivers' hands entirely alone. Never, even in 
panic times, buy a bond yielding over 6^ per cent., or 
a short term note yielding over 7 per cent., as the high 
yield is evidence of great risk. It is unsafe to buy rail- 
road bonds yielding over 5^4 per cent., or industrial 
bonds yielding over 6*4 per cent. 

(4) The bonds and stocks of companies which have 
made less than three annual reports of earnings are un- 
seasoned, and are to be generally let alone. 

(5) Unlisted mining stocks, together with the great 
majority of those listed on curb exchanges, should not 
be touched. 

Even in the selection of bonds it is a money-saving 
plan not to buy the bonds of companies which increase 
their capitalization too rapidly. From this point of view 
it may be said that capitalization is growing too rapidly 
when the rate of increase much exceeds the rate of in- 
crease in gross earnings — taking the average from three 
to five years as a basis. Such a policy during the past 
few years would have saved New England investors 
millions of dollars' loss in New Haven securities. 

In following this plan it is of course an extremely 
important question when to buy low-priced speculative 
shares of promise; for if not bought cheaply they will 
not fulfill their promise of profit. Manifestly there 
cannot be any fixed rule, but the occasions for buying 
come only once in two to five years. Bankers, stock 
and bond brokers and other expert judges of financial 



274 Sound Investing 



conditions need no instruction when to buy. However, 
those who da not devote themselves to banking and 
finance will find the course of the bond market to be 
the best practical guide. A number of financial papers, 
including the Wall Street Journal, the Boston Commer- 
cial, and others, publish averages showing the course of 
bond prices; and these may be very useful to the occa- 
sional buyer of stocks. 

Those not especially familiar with the intricacies of 
the interpretation of financial statistics will find it best 
to be guided entirely, and almost blindly, by these bond 
averages, and to follow the method of interpretation of 
these averages given in Chapter 42. Through this policy 
one may sometimes fail to take advantage of an upward 
movement in security prices, but more often he will 
avoid the purchase of speculative securities right in the 
middle of a bear movement when great depreciation of 
prices is yet to occur. These recommendations are based 
of course upon the obvious fact that it is best for sala- 
ried people to act conservatively. 

After bond prices have risen seven or eight points 
from the highest point of a recent bear movement and 
stock prices have risen at least twice as much, it is time 
to consider the advisability of exchanging from the 
securities last mentioned above to a more stable class 
of investments. In making this exchange salaried people 
may reasonably attempt to interpret the generalizations 
in Chapter 42, because even if they make an error it will 
involve no loss of principal, but only some reduction of 



Salaried People 275 



the rate of income received. As a list to hold during a 
bear movement the following may be suggested: 

15 per cent, in U. S. government bonds yielding 1J4 to 3% 
20 per cent, in foreign government bonds yielding 3^4 to S%% 
15 per cent, in bonds of various states yielding 3 l / 2 to A%% 
30 per cent, in lowest yield municipal bonds netting 4 to 4^6% 
20 per cent, in lowest yield equipment trusts netting 4% to 4$i% 

Naturally a great many persons of moderate means 
will not have a sufficient investment account to subdivide 
it in this manner. However, this presents no difficulty, 
since any one of the classes of securities here mentioned 
will prove entirely stable and satisfactory during a gen- 
eral decline or even a panic. The reason for advising 
the selection of municipals and equipment trusts show- 
ing the lowest yields is that these are the very securities 
which also show the very least depreciation. Absence 
of depreciation at such times is far more valuable than 
an increase of one-half a point or one point in yield. 



XXXVIII 

Investments For Clerks and Laborers 

//rnr^O him that hath shall be given", is nowhere 
better illustrated than in the investment 
-*- field. The man who has thousands to in- 
vest has everything to assist him. In the first place, 
the great mass of bonds are in thousand dollar denom- 
inations, thus giving him his choice of all the tens of 
thousands of bonds issued in the United States and other 
countries. Secondly, there is enough commission or 
profit for the broker on his thousand dollar investment 
so that his business is well worth having, for which rea- 
son he can obtain free no end of expert advice. Stock 
exchange houses, bond houses, trust companies and na- 
tional banks all stand waiting at his elbow to give him 
the best of their services and opinions. If in doubt, for 
example, as to which of two bonds he will choose, he 
can go to the statistical department of a big bank, trust 
company or bond house, and obtain every minute detail 
as to the merits and demerits of the two bonds. 

Thirdly, his thousand dollar investment means that 
he moves among thousand dollar friends. That is to 
say, many of his friends are keen and successful busi- 
ness men who are themselves expert judges of invest- 
ments, and are often able to advise him of excellent 
opportunities. Fourth, his contact with bankers and 

(277) 



278 Sound Investing 



financial men gives his mind a training which a clerk 
or laboring man can seldom attain. He learns which 
are the most reliable bond houses, which are the most 
conservative railroads and corporations, where to find 
the quotations of their bonds, how to figure the yields, 
and how best to handle the whole matter to his own 
advantage. 

Thus it happens that the smaller the investment the 
more difficult it is to handle it successfully. To still 
further demonstrate the old Bible saying just quoted, 
this greater difficulty in handling the smaller investment 
has to be met, not by the banker whose financial skill 
fits him to meet it, but rather by the clerk or laboring 
man whose daily routine of drudgery prevents him from 
ever acquiring financial skill. This chapter, therefore, 
is to those who do not know how; and those who do 
know are invited to stop reading before being wearied 
with recitals of knowledge they already possess. 

Primarily the investment account of a clerk or labor- 
ing man is a savings account; and his principal reason 
for investing the money in securities himself, rather than 
letting a savings bank do it for him, is that he wants the 
additional income. Savings banks will pay him 4 per 
cent, on his money, whereas they themselves obtain 5, 
Sy 2 or 6 per cent. This extra 1 or 2 per cent, pays the 
savings banks only a moderate profit over and above 
operating expenses. However, the small investor wants 
to get this profit for himself. His first principle, there- 
fore, is that he must not buy any security which is less 
safe than a savings bank deposit. 



Clerks and Laborers 279 

Second comes the question how to select such securi- 
ties. He cannot well select them himself because of 
lack of training and experience, and he must, therefore, 
obtain advice. To obtain good advice is always diffi- 
cult, and his best method will be to seek it from some 
personal acquaintance who successfully handles consid- 
erable investments for himself. It is equally important 
to observe how and from what source he should not 
obtain this advice. 

First, he should not obtain it from the clerks or under- 
lings in any savings bank, trust company, bond house or 
stock brokerage firm. Such counsel generally proves 
worse than useless. The writer recalls being advised by 
the receiving teller of a well known bank to buy a bond 
which never was anything but an outrageous specula- 
tion, and which later sold at 25 cents on the dollar. 
Second, he should not imagine that when he steps into 
the private office of some high official of a bank or a 
bond house, he is in the) holy of holies. On the contrary, 
le is in the office of a firm which has goods to sell, and 
is going to try to sell them; and the advice he gets is 
no more certain to be disinterested and literally truth- 
ful, than is the advice he gets in a high class department 
store as to the character of the goods offered for sale. 

Third, if he seeks information from the investment 
department of magazines or newspapers, he should bear 
in mind that the financial interests of these publications 
are generally identified with those of their advertisers 
rather than those of their subscribers. If, for example, 



280 Sound Investing 



such an investment department at one stroke incurs the 
enmity of a subscriber by getting him to purchase a 
fourth rate bond at a first rate price, and secures the 
friendship of a financial advertiser by bringing about 
the sale of said bond at a high price — the newspaper 
will not lose thereby. The loss of a subscriber will 
amount to a few paltry dollars per annum, whereas the 
additional advertising obtained may count into hundreds 
and even thousands. 

It is not meant that there is anything more than the 
average percentage of dishonesty amongst either finan- 
cial publications or dealers in securities. All that it is 
intended to point out is that in going to such an invest- 
ment department of a newspaper or magazine for ad- 
vice, the clerk or laboring man is relying on those who, 
if they are dishonest, can make a profit by deceiving 
him. The great majority of dealers in bonds show more 
than average honesty, and the investment departments 
of magazines and newspapers are as honest as they can 
afford to be. Indeed, there are some which steadily 
refuse to give untruthful advice even though by so doing 
they might secure valuable advertising. 

The sum of the whole matter of advice is that the 
uninitiated must obtain from some personal acquaint- 
ance whose ability to invest wisely, and whose disinter- 
estedness are both beyond question. A good method is 
to write to the inquiry departments of some prominent 
financial magazines and newspapers, and also to two or 
three of the best known bond houses, and ask for the 



Clerks and Laborers 281 

names of a few of the best and safest hundred dollar 
bonds and preferred stocks. The answers will not be 
long in coming, as all of these houses have a personal 
interest in developing a patronage or clientele. After 
a few of the answers have been received, it is then a 
good plan to take them to one's savings bank, or em- 
ployer, or to the trustee of some estate, or to any fair- 
minded man who has had broad experience with invest- 
ments, and ask to have the best selections from the list 
received. 

As already observed, only the safest securities should 
be bought. In practice these are of two classes : First, 
there are high grade bonds; and second, the best pre- 
ferred stocks listed on the leading stock exchanges are 
safe, if bought five points or more below the average 
prices, especially for a period of years. As to bond in- 
vestments the person of small means is of course limited 
to issues of small denominations. On this account there 
is appended hereto a list of good hundred dollar bonds. 
Any of these are quite safe; but of course the greater 
safety is to be had by buying only one of each of the 
bonds selected. It is the old principle of not putting 
your eggs all in one basket. 

About two-thirds of the investment should be put into 
bonds of this type, and the other third, when prices are 
low, may well be put into stocks. At, or near, the bot- 
tom of a bear market, good stocks with long dividend 
records are almost as safe as bonds; and they have the 
advantage that in the succeeding bull market their prices 



282 Sound Investing 



go up 20 to 50 per cent. « The selection, however, must 
be made carefully, as it is only a very small minority of 
stocks which can really be considered as safe as a sav- 
ings bank account in practice. Hence, the qualifications 
of such stocks may be enumerated. 

Only those which are listed on the regular — not curb 
— exchanges of New York, Boston, Philadelphia, Chi- 
cago, Montreal and Toronto should be bought. Those 
of companies which have made less than five annual 
reports, giving both an income account and a balance 
sheet, should be let alone. The stock selected during the 
last four or five years reported on should show surplus 
earnings equal to at least 150 per cent, of dividend re- 
quirements, and even in the poorest year out of five it 
should have earned its dividend. The capitalization of 
the company issuing said stock should not during the 
past four or five years have increased any more rapidly 
in percentage than its gross business and net earnings. 
Stocks which have not paid continuous dividends 
through at least one severe business depression like that 
of 1893 or 1907, should not be bought. 

It is true that the issues which can meet these stiff 
requirements are few and far between, but so are the 
stocks which can safely be held as a substitute for a 
savings bank account. 

Manifestly the time to buy is around the end of a bear 
movement. But when is this? It is futile to give com- 
plicated methods of analysis, since the man unfamiliar 
with finance could not use them; and therefore a per- 



Clerks and Laborers 283 

fectly definite course of action must be suggested, and 
this must err on the side of safety. One who observes 
the following three rules will either err on the side of 
safety, or not err at all. 

(1) Wait before buying one full year from the date 
on which the last bull market ended, as indicated by the 
Wall Street Journal's average of twenty rails, or by the 
average given in Dun's Review of sixty rails. 

(2) Even then do not buy until some of the leading 
averages of the bond prices have gone off at least 8^4 
points, and then rallied at least one point, and held above 
the lowest at least two months. 

(3) Even then do not buy unless one of the above 
averages of railroad stock prices has shrunken since the 
top of the last bull movement by at least 20 per cent, 
of itself. 

The man who follows these stringent rules will buy 
the right stocks, and get them at approximately the 
right time. If he does not know just how to follow 
them, an adviser such as referred to above can tell him. 
He is then in a position to wait for a profit of 10 to 30 
per cent, on his stocks, and then exchange them into 
first class bonds. This exchange should be made at the 
very time when stock prices are booming and labor is 
fully employed, and everybody is talking prosperity. At 
such times, when one steps into a brokerage office, he is 
sure to be advised to buy more stocks instead of selling 
what he has ; but if he sticks to his purpose, and follows 
a very conservative course of action he will profit 



284 Sound Investing 



thereby. Still better than exchanging from stocks into 
bonds, or even from low grade bonds into the very best 
is the policy of selling out one's security holdings at 
such a time and put the money in the savings bank, and 
leave it there throughout the next ensuing bear move- 
ment. Especially is this true of an investment fund 
totalling less than $1,000. 

Difficulties there are indeed; and the chief difficulty 
is that nine-tenths of small investors lack the will-power 
and consistency of purpose to stick to such a plan. Tak- 
ing advice becomes a sort of habit or disease, and a 
person who will take advice from one man is likely to 
take it from another. Hence, though he may start out 
well enough and do the right thing, he is extremely apt 
to be dissuaded from his original purpose, and be in- 
duced to buy worthless or very poor securities from 
that small and crooked minority of financial houses 
which so injures the reputation of all the rest. 

Good $100 Bonds Int. Due 

Anglo-French external loan 5% 1929 

American Gas & Electric collateral trust 5 2007 

City of Baltimore, reg 4 1951 

City of Chicago 4 1927 

Chicago, Milwaukee and St. Paul convertible 4}4 1932 

Chicago, Milwaukee and St. Paul convertible 5 2014 

Colorado and Southern refdg. and ext Ay 2 1935 

Cleveland Electric Illuminating Co. 1st mortgage 5 1931 

Chicago, Burlington and Quincy ext. coll. tr 4 1922 

Denver Gas and Electric first 5 1949 

Diamond Match Co. conv. deb 6 1920 

General Electric 3V 2 1942 

Keokuk and Des Moines 1st mortgage 5 1923 

Liggett and Myers 7 1944 

P. Lorillard 7 1944 

Laclede Gas Light Co. 1st mortgage 5 1931 



Clerks and Laborers 285 



Good $100 Bonds Int Due 

Montana Power 1st and refunding 5 1943 

New York Air Brake 1st mortgage 6 1928 

Newark Gas Co. first 6 1944 

New York Central convertible debenture 6 1935 

San Francisco Terminal first 4 1950 

Schenectady and Duanesburg first 6 1924 

State of Louisiana 5 1929 

Western United Gas & Electric 1st and ref 5 1950 



XXXIX 

Investments For 
Women and Dependents 

THIS is the tenth and last of the principal classes 
of investors whose needs have been discussed 
in these chapters. Of course the class of people 
here referred to are not women and dependents who 
are beneficiaries under trust instruments, but rather 
those who come into the direct ownership of securities. 
A competent trustee has the knowledge and the touch 
with financial conditions to enable him to handle an 
investment in a somewhat more profitable manner than 
can be done by a person with less experience and finan- 
cial skill. 

For this class of investors the first and almost the 
only consideration is safety of principal. They cannot 
afford to lose, and therefore should not take risks; and 
the same principle applies to purchases by experienced 
business men of securities which are to be left to their 
wives and dependents. Moreover, the rule of "safety 
first" should be followed very strictly. There are hun- 
dreds of bonds or even stocks which under existing busi- 
ness conditions are perfectly safe, but which under the 
conditions which existed a few years ago, or which may 
exist a few years hence, would not be safe at all. Hence, 
one must so far as possible pick out securities of a per- 

(287) 



288 Sound Investing 



manent character which are safe under any conditions. 

Permanence is not a characteristic of financial mat- 
ters; and bonds, generally speaking, do not have a per- 
manent status. Many which looked perfectly good a 
few years ago have now proven to be third or fourth 
rate investments, while some which were semi-specula- 
tive have become first or second class investments. Even 
the best bonds change their position in accordance with 
the changing worth of capital. Ten or fifteen years ago 
new capital was worth 4 per cent, whereas it is now 
worth 5, and correspondingly the very best bonds have 
sold down from a 4 per cent, basis to a 5 per cent, basis 
or thereabouts. These are but two of the many factors 
which make it difficult to select permanently # good and 
safe investments. 

In leaving securities to posterity or dependents there 
is of course no way to guard against changes in the 
worth of capital; but other valuable precautions may 
be taken. Bonds may be selected which have in them 
the elements of permanent value. These elements are, 
first, an abundance of physical assets, and second, sta- 
bility of assets. Assets are like chemical compounds 
in that some of them are very stable in character, while 
others dissolve from almost any cause or no cause at all. 
Good-will is an asset of the latter kind; for in many 
instances it is extremely valuable, and yet in almost 
every case it is unstable and its value may disappear 
almost any moment. 

Going still further, assets which are purely physical 



Women and Dependents 289 



vary immensely in the permanence of their values. For 
instance, farm property is an asset which for hundreds 
of years has maintained or increased its value ; but canal 
property, generally speaking, is probably not worth 5 
per cent, of what it was in 1840. Even among the vari- 
ous kinds of physical assets which are in constant use 
at present, there is a great difference in permanence of 
value. Railroad property has about as permanent a 
value as any, because it is practically certain to retain 
its usefulness regardless of the fortunes of its present 
owners. By way of contrast, summer hotel property, 
even though valued 10 or 20 per cent, below its cost, 
if quite lacking in permanence of value, because its earn- 
ing power is apt to be destroyed any moment by loss of 
popularity. 

What not to buy is perhaps just as important a ques- 
tion as what to buy. For women and dependents no 
stocks whatever should be bought, because they lack per- 
manence of value. They carry no liability except when 
dividends are guaranteed or cumulative, and even such 
a liability is in many cases not very binding. Cumula- 
tive provisions are easily dodged, and even high grade 
stocks whose dividends are guaranteed by solid corpora- 
tions yield no more than bonds, so that there is no ad- 
vantage in buying them. 

There are a great many mill stocks which are first 
class investments, and not a few which will doubtless 
remain so for decades; but they should not be bought 
by or for this class of investors because there is noth- 



290 Sound Investing 



ing to secure their permanence of value. If that value 
remains it will be largely a matter of good fortune. A 
board of directors is not obliged to declare dividends. 
Bank stocks, broadly speaking, are still better invest- 
ments, but these also should be avoided for two reasons. 
First, it requires a special knowledge of bankers and 
banking; and second, the investment value of even the 
best of such stocks so continually changes as to require 
constant watching. 

Short term notes should be avoided by these investors 
for the obvious reasons that funds so handled would 
have to be frequently re-invested, and that it requires 
considerable business experience to distinguish safe from 
unsafe notes. Debenture bonds are disqualified as a 
rule by the lack of assets behind them, and the same 
may be said of the great majority of convertibles. Even 
the small minority of the latter in which the convertible 
privilege is really valuable are hardly suitable for women 
and dependents because of the difficulty of knowing just 
when and how to convert or sell them and reinvest the 
money. 

Hotel bonds and a great many other real estate securi- 
ties are unsuitable, because their earning power depends 
so much upon popularity and other rapidly changing 
conditions. Manufacturing company bonds with excep- 
tions of course, are disqualified by the rapid rate at 
which manufacturing plants depreciate, and by the in- 
stantaneous 30 to 70 per cent, depreciation which takes 
place in its assets when a manufacturing concern ceases 



Women and Dependents 291 

doing business. Copper mining bonds, and also coal 
and other mining bonds are unsuitable for women and 
dependents because of the extreme uncertainty as to 
ore reserves and underground conditions, and also be- 
cause of the frequent lack of proper sinking funds and 
other safeguards which characterizes many such bonds. 
Irrigation district bonds are also rather unsuitable. 

Having observed what to avoid, it is worth noticing 
what particular classes of bonds are the most likely to 
show the safety and the permanence of value which are 
to be desired. In the first place, it is quite futile to try 
to find permanently safe and sound securities of the type 
described above which will show a high yield. There 
are no such. Five per cent, is now almost the exact 
worth of new capital, in normal times, as proven by the 
fact that it is the average yield of a very large number 
of new bond issues made throughout the United States 
in recent years. Practically speaking, the more one's 
bonds yield over 5 per cent, the greater is the risk; and 
the more their yield falls below 5 per cent, the greater 
are the excesses of the physical assets underlying the 
bond over and above the market value of the bond. 

Of course yields vary among absolutely safe and se- 
cured bonds. Unappreciated securities sell higher than 
others. Likewise those representing companies which 
are operating in localities far distant from the centers 
of capital are apt to sell low and show high yields. Small 
and relatively unknown issues of bonds are likely to 
have such a narrow market as to sell cheap. Consider- 



292 Sound Investing 



ing all these factors, the following subdivision or diversi- 
fication is suggested: 

5 per cent, in bonds of various states yielding 3j£ to 4&% 

25 per cent, in municipals yielding AYz to 5^4% 

10 per cent, in foreign government bonds yielding 4 to 6j4% 

25 per cent, in railroad mortgage bonds yielding 4$i to S}i% 

15 per cent, in gas and electric light bonds yielding 4% to 5^% 

10 per cent, in equipment trusts yielding 5 to 6% 

10 per cent in underlying street railway bonds yielding 5 to 

If the total fund to be invested is too small to be sub- 
divided in this way, the best bonds to select under ordi- 
nary conditions are municipals, railroad mortgage bonds, 
showing low yields, and foreign government bonds of 
the stronger nations. Even these issues, in spite of 
their low yields will pay considerably more than a sav- 
ings bank account, and will show so little depreciation 
during a bear movement that they can be held year after 
year, somewhat regardless of conditions. They require 
the minimum of study and attention, 



SECTION IV 
PRACTICAL SUGGESTIONS 



XL 

Finding the Desired Security 

THE investor, having decided upon the kind or 
type of security he desires, will have more or 
less difficulty, if unfamiliar with investment 
matters, in finding just the stock or bond he wants. 
The ordinary method is to go to one's bank or bond 
house, or to some stock exchange firm, and accept the 
advice offered. This method has both its advantages 
and disadvantages. Banks and stock and bond houses 
generally are themselves the sellers of goods, or are 
identified directly or indirectly with the sellers of goods. 
Their advice, therefore, is unlikely to be absolutely im- 
partial. Even if they themselves have no stocks or 
bonds to sell, it is customary for them to receive a com- 
mission from the bond house on all the business of the 
customers whom they send to that house. This is a 
point of very small importance, but it does make a dif- 
ference between absolute impartiality and moderately 
biased judgment. 

Another disadvantage in this method is that every 
man is more keenly interested in his own needs and re- 
quirements than any adviser whom he can find. With 
moderately good judgment, then, the larger efforts 
which he will make to satisfy his own needs will bring 
better results than the snap judgment which he will 

( 293 ) 



294 Sound Investing 



obtain from an adviser. Hence, it usually pays to hunt 
out one's own stocks and bonds from lists which afford 
a considerable variety to select from. 

Furthermore, it is desirable to divide one's invest- 
ments between new issues and old seasoned issues, and 
this is another reason for making one's own selection. 
Financial houses are naturally and properly much more 
interested in selling a new issue upon which they re- 
ceive a commission of one-half of 1 per cent, to 2, 3, or 
even 4 per cent., than they are in selling an old sea- 
soned bond or stock upon which the commission is 
only one-eighth of 1 per cent. Still further, the old 
seasoned issue has an average depreciation much less 
than the new issue. 

It is important, then, for the careful investor to know 
how and where to find the security which will fit his 
precise needs. Hence, even though the sources of in- 
formation on this point may change in time, there are 
here given some of the best of these sources, as they 
are at present. 

For finding the great majority of stocks and bonds, 
the Commercial and Financial Chronicle of New York 
is more than worth the subscription price. It gives 
not only the daily and weekly quotations of securities 
listed on the principal exchanges, but also the monthly 
quotations of street railway, industrial, mining, public 
utility, municipal and other securities, whether listed or 
not. Valuable sources from which to obtain both 
quotations and lists are the Wall Street Journal, the 



Finding the Desired Security 295 

Saturday evening issue of the New York Sun, the Bos- 
ton News Bureau, the Boston Commercial and the 
Annalist, published by the New York Times. 

The Wall Street Journal contains excellent lists and 
quotations of short term notes and public utility stocks, 
to say nothing of the ordinary stock exchange securi- 
ties. The Saturday evening edition of the Sun fur- 
nishes the current yield of all the leading dividend- 
paying stocks on the New York exchange. The Boston 
News Bureau and the Boston Commercial are the best 
generally available sources of information regarding 
copper stocks. The Annalist gives not only the general 
quotations of listed securities, but also those of many 
unlisted stocks and bonds together with the prices of 
quite a number of governments, municipal and public 
utility securities. 

Amongst the other valuable helps to the investor, 
Moody's Magazine from time to time gives lists of 
One Hundred Dollar bonds, which are particularly help- 
ful to the small investor. The Magazine of Wall Street 
publishes every two weeks an Investment Digest which 
contains in brief, pithy paragraphs the news, such as 
earnings, dividends, etc., regarding scores of different 
corporations. 

For lists of municipal bonds the Commercial and 
Financial Chronicle is the best source, since the lists 
are very extensive. Besides this, the State and City 
supplement of this publication gives information as to 
the population, wealth and debts of thousands of muni- 



296 Sound Investing 



cipalities. By the use of these statistics one can make 
any desired selection of municipal bonds. 

For United States bonds, foreign government bonds, 
bank stocks and mill stocks, the circulars of bond houses 
are the best source. Bank stocks are pretty fully 
quoted in the monthly quotation supplement of the Com- 
mercial and Financial Chronicle, but no information is 
given as to earnings, dividend payments and the like. 
There are bond houses which specialize in all these 
groups of stocks and bonds, and their circulars together 
with their advice are of the greatest assistance in making 
selections. Stock and bond houses in Boston, Lowell 
and Fall River can furnish lists together with quota- 
tions and general information regarding mill stocks. 
The Journal of Commerce of New York also occasion- 
ally publishes the quotations of many of these stocks. 

There are also books which are of the greatest assist- 
ance. Among these the best known are Moody's 
Analyses of Investments, Poor's Manuals and the Cop- 
per Handbook. The two former are published in New 
York, and the latter in Houghton, Michigan. Poor's 
Manuals give the income accounts, balance sheets and 
other statistics taken from the annual reports of rail- 
road, industrial, and public utility companies, but fur- 
nish no opinions upon their securities. The Copper 
Handbook does give opinions in a broad and general 
way; and Moody's Analyses gives opinions upon thou- 
sands of standard bonds and stocks in a very definite 
way. This is accomplished by assigning to each security 



Finding the Desired Security 297 

a rating, similar in principle to Dun's and Bradstreet's 
ratings, of the financial standing of business houses. 
The investor having selected a number of securities to 
choose from can readily turn to these books and learn 
from the ratings which are the best stocks and bonds. 

Besides these publications, there are scores of others, 
each having its own peculiar value. This Chapter is 
not intended at all as a catalogue of publications, but 
is offered merely as a help to the investor who does not 
know where to turn. It is of course quite unnecessary 
to subscribe to all or any large portion of these publica- 
tions, but a moderate yearly investment in them will pay 
for itself several times over, even if one's funds do not 
amount to any more than $1,000. 



, 



XLI 

Selection of a Bond House 

IN practice it is really more important to the 
typical investor to select a good bond house 
than it is to study the various methods of dis- 
criminating between good and bad bonds. The investor 
is primarily a business man engaged in some other line 
of business, and could never in his spare time become 
an expert in analyzing bond values; but if he succeeds 
in choosing the right house he will thereby get the bene- 
fit of expert analysis made by men who are both 
thoroughly qualified and strictly honest. There is per- 
haps no great business or profession in the world 
wherein a higher type of honesty prevails than in the 
stock and bond business; and this is actually true in 
spite of all the scurrilous attacks that have been made 
upon Wall Street for a century. Members of legiti- 
mate stock exchanges, and bond dealers, habitually make 
contracts involving large sums of money by word of 
mouth, and they keep them even in the absence of any 
binding evidence. 

The three things to guard against in selecting a bond 
house are, in their order, bad judgment, carelessness and 
bad intentions. By bad judgment is meant failure to 
estimate correctly the earning power, financial standing 
and general soundness of an operating company whose 

(299) 



300 Sound Investing 



bond is being sold by the bond house. It quite occa- 
sionally happens that a house having perfectly good in- 
tentions exercises such poor judgment as to involve 
its clientele in heavy losses. Indeed one or two 
houses might be mentioned which, in addition to rather 
poor judgment, have had remarkably bad luck in be- 
coming allied with bond issues which, although appear- 
ing perfectly good, were rotten at heart. Carelessness 
when it occurs usually takes the form of relying too 
much on some other house. It sometimes occurs that 
several bond houses join a syndicate and purchase a 
new bond issue which has not been investigated — each 
in the belief that one of the other houses has made 
a thorough investigation. 

Although the standard of honesty among bond houses 
as a class is very high, it is not a matter of course 
simply because a given house is big, old and well known, 
that it is therefore reliable. Full page advertisements 
do not prove reliability; and some houses, like some 
merchants and manufacturers, have been known to first 
develop a good reputation and then use the same as 
a means of selling cheap goods at a high price. The 
writer recalls the visit of a salesman representing a 
house which is both very old and very well known, 
who solemnly asserted and positively insisted that the 
gross earnings of a company whose bond he was selling 
were more than four times as large as they actually 
were. Therefore investigation is really necessary in 
spite of the high standard of honesty. 



Selection of a Bond House 301 

. i i . ■■ ■ i n - Ill II ■ ■ ! i.i 

Primarily the business of a bond house is to buy an 
entire issue of bonds and distribute them amongst its 
customers. It buys wholesale and sells retail. Often- 
times the operation instead of being conducted by a 
single house is carried out by a group of houses known 
as a syndicate. Especially is this true of the many 
smaller houses, any one of which is too small to pur- 
chase outright an entire bond issue amounting to mil- 
lions of dollars. There are, however, houses which 
control the properties whose bonds they sell. If the 
properties are prosperous, as is the case with a well 
known house which develops and manages street rail- 
way concerns and sells their bonds — this is an advan- 
tage, since the house is then in possession of absolutely 
first hand information on every point concerning the 
properties. But if the properties should meet with any 
long series of misfortunes, any such house would be 
tempted to save itself by obtaining the necessary new 
capital for the properties, and by doing so through 
over-stating the merits of the new securities issued. 

No concern, whether a bond house or a manufac- 
turer of goods, can be both maker and seller without 
having to meet the temptation to exaggerate the merit 
of that which it makes and sells. In some instances 
this combination of two businesses in one has led to 
serious losses to the investing public; but in others the 
objection is more theoretic than real. It can be stated, 
however, that the man who buys bonds of a house in 
control of the companies issuing the bonds should, 
before purchasing, make a general study of the earn- 



302 Sound Investing 



ings, not only of the company into which he is buying, 
but also of the other companies controlled by the bond 
house. If he finds them to be prosperous it is a safe 
inference that the house is not under temptation to 
misrepresent. 

As between large and small houses there is no pre- 
sumption that the one is better than the other. The 
large house may offer a larger number of bonds to 
select from; but on the other hand the small house is 
often so closely allied with a number of other small 
houses that it can offer a wide selection. It is allied 
with them through buying bond issues for joint account; 
and besides this, if it is regardful of the interests of 
the customer it will purchase for him from whatever 
sources it can be obtained a bond suitable to his needs 
and receive for the service only a nominal commission. 

On the other side it should not be overlooked that 
the small investor is welcomed in the large house. Such 
concerns employ very large forces, and like banks, are 
prepared to handle any amount of business in small lots. 
The great majority, even of the largest banks and trust 
companies in the United States, are glad to receive 
small accounts of only a few hundred dollars because 
these increase operating expenses only in a slight de- 
gree and in the aggregate add substantially to net earn- 
ings. So it is with the great bond houses. Their equip- 
ment is unexcelled, and their forces are so large that 
even the purchaser of a single $100 bond can get all the 
personal attention he may desire. 



Selection of a Bond House 303 

The real question is not size, but quality or standard. 
Selecting a bond house is a task no different from 
that of investigating the credit of an individual. A 
good way to begin is to make inquiries from the 
national bank, trust company or savings bank with 
which one does business. Incidentally it is worth men- 
tioning that a great many bank depositors, through their 
own fault, do not obtain from their banks even half of 
the services which the latter are perfectly willing to 
render. The officials of your bank from cashier up to 
president — not from paying teller down to office boy — 
are in a position to know who is reliable and who is 
not ; and as they want to see your account increase they 
are ready to give you impartial advice. Further than 
this, the trustee of an estate or anyone who has had 
long experience in investing money is likely to know 
which bond houses are worthy of your confidence. 

An important point to remember is that it is not the 
bond house as an institution, but rather its personnel 
that one must rely upon. A very old house through 
a change of personnel may become less reliable than 
its name implies; and a young house if managed by 
men of experience, ability and integrity may be thor- 
oughly reliable. It is an individual question. 

One of the best criterions, and one which is available 
to all, is the study of bond circulars themselves. To 
obtain these it is only necessary to write a dozen let- 
ters to different houses announcing one's intention to 
buy some bonds. If, upon examining these circulars, 



304 Sound Investing 



it is found that a given house is issuing and recom- 
mending bonds against a company which is in process 
of construction or development and is not yet actually 
showing net earnings, it is wise to resolve at once to 
do no business with that house. All good bonds at 
the very date of their issue earn their interest once 
and a half or twice over and a bond which has not 
yet begun to earn its interest is not a bond at all. 
It is merely a stock sold under misrepresentation. This 
is still true even though it may be a first mortgage on 
land or concessions, or rights of way which are to 
be used in building up the proposed company to a point 
where it can earn money. 

About the only exception is the case of a mortgage 
bond issued against non-earning property such as land 
or timber, for example, which property is actually 
salable at a price equivalent to 125 to 150 per cent, 
of the amount of the bond issue. One must not, how- 
ever, assume that land, concessions or timber rights 
necessarily have a real market value equivalent to the 
valuations given in bond circulars; for as a usual thing 
the book values given in balance sheets are merely 
technical and greatly exceed actual market values. As 
a general average the capitalization of new corpora- 
tions is equivalent to 175 or 200 per cent, of the actual 
cost of the physical property owned. 

Another feature of bond circulars which should be 
examined is the character of the statements made re- 
garding a given company. If the circular is full of 



Selection of a Bond House 305 

details as to gross and net earnings, operating expenses 
and interest charges, it should command confidence. 
Especially is this true if these statements of earnings 
and expenses cover a period of years, and are accom- 
panied by full explanations. But if in the place of 
these pertinent facts the circular is filled up with a 
glorification of the industry or the locality in which 
the given company is engaged, the investor should at 
once become suspicious. The greatness of a city will 
not save an overcapitalized or mismanaged street rail- 
way company from receivership, nor will the magnifi- 
cence of a farming district pay the interest on the 
bond of an irrigation company whose expenses exceed 
its income. 

A third test which may well be applied in judging 
a bond house by its circulars is to be found in an in- 
spection of the yields offered. In the second chapter 
of this book it is shown about how much securities of 
different classes ought to yield in normal times. If a 
house promises yields much in excess of these figures, 
and at the same time asserts or guarantees that the 
security is strictly high grade, this is a sufficient cause 
for distrust. To take a concrete illustration, the yield 
of really first class underlying railroad mortgage bonds 
is from 4% to 4j4 per cent., and seldom exceeds 5 
per cent. Possibly it would be safe to say that it 
never does so. Now if a circular offers what is repre- 
sented to be an underlying railroad mortgage bond, and 
offers it on a Sy 2 or 6 per cent, basis, the house issuing 
the circular is a good one to let strictly alone. 



306 Sound Investing 



Much can be learned through personal conversation 
with representatives of various bond houses, especially 
if one calls at the offices of the house itself. Bond 
salesmen, even of the best houses, occasionally indulge 
in exaggerations and false promises in spite of all 
the care exercised in avoiding the employment of such 
salesmen. However, upon making a personal call, if 
the investor is told by one of the responsible men in 
the office that the house will guarantee that the price 
of a given bond or note will never fall below a certain 
limit, he may know that the house is not to be relied 
upon. Accidents can happen to any company, however 
well managed, and it is utterly impossible to honestly 
hold out any such guarantees. 

Then too, the attitude of a house toward inquiries 
as to earnings, assets, etc., is very enlightening. A 
reliable concern will meet any reasonable question with 
a frank answer, and will take pains to give all the 
pertinent facts desired regarding any bond or the 
company which issues it. Practically all good houses 
maintain statistical departments for the very purpose 
of accumulating such information and having it ready 
at hand. An unreliable concern, on the contrary, is apt 
to meet such inquiries with a superior air, and bluntly 
hint that the mere asking of the question is a slur upon 
the integrity of the house. 

Furthermore, a reliable house will be able and willing, 
except in times of financial stress, to find a market for 
your bond at only a slight concession from the price at 
which they would be ready to sell you the same bond. 



Selection of a Bond House 307 

A concern which merely sells to you, and never assists 
you when you desire to sell, deserves no confidence. All 
good houses do quite the contrary. It is not infre- 
quent for a bond house to resell on behalf of its cus- 
tomers an amount of securities equal to 10 to 20 per 
cent, of its total yearly sales of new issues. 

Finally one can, if he so desires, study out the re- 
liability of a house by obtaining a list of its past bond 
offerings and observing how many of these went wrong. 
Such lists are published every year and are in the hands 
of every large investment house. Having obtained a 
fairly complete list of the important issues of a given 
house for a number of years past the investor can 
then consult Moody's Analyses of Investments and find 
the rating of each bond. If the ratings run high it is 
a sufficient indication that the house in question de- 
serves his confidence. 

It cannot be too emphatically stated that these sug- 
gestions imply no disrespect to bond houses, and no 
reflection upon their integrity. If the standard of 
honesty were as high among all business men as among 
bond dealers, we could strike half the laws from the 
statute books and close half the jails. However, the 
inexperienced investor, like all inexperienced persons, 
is the most apt to place his faith in those who hold 
forth the most golden promises. Thus it is that so 
many persons have been defrauded, and that the re- 
liable stock and bond houses have not yet received the 
high appreciation which their usefulness and integrity 
deserves. 



XLII 

How and When to Buy and Sell 

HOW to buy and sell is generally known; but 
for the sake of those who are investing in 
securities for the first time a few points may 
be mentioned. Investment purchases can readily be 
made without taking the trouble to go to a stock ex- 
change firm or a bond house. One has only to give the 
order in writing to his bank, trust company or savings 
bank; and in due time the certificate will be waiting for 
him at the bank. If he intends to hold permanently it 
is wise to have the certificate transferred into his own 
name, but if his purpose is to hold only for a space 
of a few months it will be equally satisfactory and 
less trouble to receive what is called a "street cer- 
tificate," meaning a certificate which is endorsed in 
blank. 

In both buying and selling one should state the price 
which he is willing to pay, or else should make his 
order read "at the market. ,, In the case of listed se- 
curities there is no genuine advantage in setting a price, 
and the purchaser may be sure that any reputable stock 
exchange or bond house will give him fair treatment 
if the order is placed at the market. When it comes 
to speculation the fixing of prices is an entire mistake 
When a stock is going up it is a purchase at the market 

( 309 ) 



310 Sound Investing 



and it does not matter to the buyer whether he pays 
a shade more or less than the last quotation; and vice 
versa when it is going down. It not infrequently hap- 
pens that a trader who is trying to be close with his 
money misses a big and exceedingly profitable rise by 
placing his buying order at somewhat too low a price, 
and thereby failing to obtain the stock. 

The really important subject of this Chapter is the 
when. In order to carry out the investment policies 
outlined in previous Chapters it is absolutely necessary 
that one should know with a fair degree of certainty 
approximately when to sell out unstable securities in 
preparation for a bear movement, and to repurchase 
them in anticipation of a bull movement. Contrary to 
the general impression both of these subjects can be 
readily and clearly understood through a moderate 
amount of study of financial and commercial statistics, 
and without the application of any special knowledge 
or other skill over and above common sense. 

Bull and bear movements are mere reflections of the 
rise and fall of the general prosperity of the nation. 
They are perfectly simple in their nature, and it is 
almost self-evident that an era of increasing prosperity 
must necessarily be accompanied by a bull movement 
and vice versa. Stocks and bonds are the most liquid 
of all assets with the exception of cash, bank deposits 
and commercial paper. Hence when the business men 
of the United States, taken as a whole, are in need 
of money to meet their obligations they are positively 
certain to become sellers of securities and to thereby 



How and When to Buy and Sell 311 

produce a bear movement. On the other hand, when 
these business men are making money faster than they 
are spending it they are equally certain to seek a ready 
means of investing it, to buy securities and to thereby 
cause a bull movement. 

However, it is not the purpose of the writer to dis- 
cuss the theory of these movements except so far as 
is necessary to show the basis of the practical con- 
clusions to be drawn. The main purpose is to describe 
concretely the best methods of knowing when the 
movements are coming to an end. Now there are sev- 
eral items of statistics which reflect the prosperity of 
the country with more accuracy than the others, and 
which therefore may be especially singled out and used 
in determining these important points. Three of these 
are: Interest rates, pig iron prices and bond prices. 
Let us first notice why these reflect the prosperity of 
the nation accurately, and then observe the practical 
rules for their use. 

Of all the commodities the consumption of which 
can be curtailed in hard times without thereby suffering 
from cold or hunger, pig iron is the greatest and most 
important. It is one of the foremost raw materials 
entering into all manufactured products; and manu- 
facturing is the greatest industry in the United States 
next to agriculture. Furthermore, all our industries 
including agriculture are conducted principally by the 
use of machinery and mechanical appliances, and all 
this machinery is made largely from pig iron and its 



312 Sound Investing 



products. For these reasons prosperity necessarily in- 
volves a great increase in pig iron consumption, and 
depression of business inevitably brings about a sub- 
stantial decrease. Thus pig iron prices have come to be 
a barometer, provided only one bears in mind that they 
keep on rising three to six months after a boom in 
business reaches top, and keep on declining six to nine 
months after a depression reaches bottom. 

Interest rates are equally certain to reflect the rise 
and fall of prosperity. Interest is the price paid for 
the use of capital. When business is expanding every 
merchant is laying in a larger stock of goods and 
every producer a larger stock of raw materials. Both 
are increasing their plants or business outfit and are 
in need of additional capital. Hence their borrowings 
increase and the demand for capital increases. So long 
as prosperity continues to grow this demand for capital 
keeps on increasing until finally it reaches the point 
where the business men of the country have borrowed 
all the liquid capital there is, and there is no more that 
can be borrowed. These men at such times have laid 
in large stocks of goods or materials, have large pay- 
ments to meet, and therefore are seriously in need of 
additional loans. They need the loans either to avoid 
being forced to abandon very profitable business or 
else to protect their own solvency. Thus the com- 
petition for capital becomes so keen that interest rates 
go very high. 

But with the supply of liquid capital exhausted busi- 



How and When to Buy and Sell 313 

ness cannot keep on expanding. Hence the expansion 
must stop and with it there stop also the large sales 
and revenues which merchants and producers relied 
upon to meet their large payments. At this juncture 
they are forced to sell their securities to meet the pay- 
ments, and then occurs a bear movement. Goods are 
sacrificed, clerks and laborers not absolutely needed are 
discharged from employment, and the debt paying 
process begins. For a time it is a wild and universal 
scramble to get money fast enough to keep out of 
bankruptcy. Then as Peter pays Paul, and Paul pays 
Saul, and Saul pays Peter and Peter pays Paul, this 
round robin of payments gradually liquidates the in- 
debtedness of the business men of the nation; and the 
creditors find their money piling up in the banks. The 
curtailment was originally forced by the exhaustion of 
liquid capital, and that in turn forced everyone to pay 
debts or fail, and that in turn so reduced the volume 
of general business as to kill the demand for liquid 
capital. The accumulation of money in the banks and 
of funds in the hands of lenders forces interest rates 
very low at such times, and then securities are a pur- 
chase. 

Bond prices carefully studied and taking an average 
of twenty or thirty representative mortgage bonds rather 
than a lesser number, are as valuable as pig iron or 
interest rates in reaching conclusions. At the top of 
a boom in business margins of profit are very wide, and 
the typical business man discovers that he can make 



314 Sound Investing 



two or three per cent, more by employing his capital 
in his own business than he can by holding bonds. 
Thus it comes about that he sells his bonds, and this 
causes the bond market to decline right in the midst 
of the greatest general prosperity and several months 
before the stock market begins to decline. On the 
other hand, in the midst of a business depression the 
same business man finds that he has a surplus of idle 
funds which he cannot put to use because of the small- 
ness of his volume of business or sales. Hence he 
invests these funds in bonds to obtain a return on 
them, and he does this some weeks or months before 
the situation is such as to give him the courage to 
invest in stocks. Thus the bond market shows decided 
strength slightly in advance of the stock market. Fur- 
thermore, bonds are so much more stable in their values 
that the interpretation of their price movements is not 
very liable to error. 

In addition to these three barometers of prosperity, 
the investor may judge the top of a bull market by the 
evidences of distribution of securities on the part of 
the largest holders. He may also judge the approxi- 
mate bottom of a bear movement by the evidences 
of accumulation on the part of these men. These evi- 
dences are less certain of interpretation than the move- 
ments of pig iron, interest rates and bonds, and should 
not be used alone. Having briefly noticed these funda- 
mental principles, we may now come to the concrete 
definitions of the time to buy and the time to sell. 



How and When to Buy and Sell 315 

THE TIME TO BUY 

Pig Iron: In using pig iron as a barometer it is 
necessary to keep a monthly record of prices and this 
record should be the average of the quotations given 
in some weekly publication such as Dun's or Brad- 
street's Reviews or the Iron Age. Dun, for example, 
quotes four different grades of pig iron every week, 
and if the entire four are taken as a basis the monthly 
average price based upon 16 to 20 quotations will prove 
very accurate. 

Counting from the highest monthly average price of 
pig iron made after the termination of a bull move- 
movement in stocks, it is time to buy securities after 
these monthly averages for iron have declined for a 
space of six months and to the amount of not less than 
$3 per ton; provided however, general liquidation must 
have meanwhile been indicated either by a drop of 30 
points in some average of 20 or 30 stocks, or else by a 
drop of as much as $5 in pig iron; and provided also 
this general liquidation must have been further indi- 
cated by a continued decline from the aforesaid highest 
monthly average price, lasting at least seven months 
without a rally of as much as $1.00. 

Interest Rates: After the end of a bull movement 
in stocks when the monthly average of New York in- 
terest rates drops below Z 1 /^ per cent, it is time to buy 
securities; provided however, general liquidation must 
have been indicated by a decline of $5 per ton in pig 
iron, or of 8^ points in bonds since the date of the 



316 Sound Investing 



extreme top of the bull market in stocks, or of 30 
points in the average price of active stocks. This 
general average of interest rates should be based one- 
fourth on call money and acceptances, one-fourth on 
30 to 90 day money, one- fourth on four to six months 
money, and one-fourth on prime commercial paper. 
These quotations can readily be obtained each week from 
such publications as Bradstreet's Review or the Commer- 
cial and Financial Chronicle. The method of averaging 
should be to add together each week the highest and 
lowest rates for call money and acceptances and divide 
these four prices by four. Then obtain the average 
or middle prices of the other three maturities here men- 
tioned, and add the four together and divide by four. 
Thus is obtained the weekly average and the monthly 
average is obtained from the weekly figures. 

Bond Prices: Counting from the month during 
which a bull market in stocks makes its extreme high 
point — when thereafter the monthly average price of 
20 or 30 representative bonds has declined as much 
as 8^2 points, and has rallied from the low level as 
much as two months in time, and one point in amount, 
it is then time to buy securities. These averages of 
bond prices should be based upon the quotations of 
each week within the month. Averages such as those 
published by the Boston Commercial and a number of 
other papers are serviceable, or one can readily compile 
his own average. 

Accumulation: This word means the passing of 



How and When to Buy and Sell 317 

securities and especially stocks, into strong hands; and 
accumulation is indicated by a long lingering of stock 
prices at low levels, by their refusal to sink to new 
low levels in spite of great pessimism, and by the failure 
of all bullish manipulation. Averages of 20 to 40 
active stocks must here be used as a guide, and must 
be tabulated or charted every day. To allow time 
for the completion of liquidation in securities these 
averages must remain near the low level and must come 
back after a rally of three points or more to within 
$6 of the extreme bottom, and must do this at least 
four months after the date when the approximate 
bottom was first reached. The average monthly volume 
of trading on the New York Exchange during the four 
or five months beginning with the next month after the 
approximate bottom was first reached, and ending with 
the last month wherein prices came back within six 
points of this approximate bottom, must be less than 
13,000,000 shares. This evidence is needed to indicate 
that the liquidation is exhausted, for a large volume 
of trading always betokens a large amount of undi- 
gested securities in the hands of the public. In spite 
of all the pessimism these price averages for at least 
four months must fail to sink more than two or three 
points below the first approximate bottom or low level. 

THE TIME TO SELL 

Pig Iron: After a bull movement of 30 points or 
more in the above average of stock prices, and after 



318 Sound Investing 



pig iron prices have risen at least seven months and 
$4, it is time to sell whenever the monthly average 
price of pig iron remains at the same figure or within 
15 cents thereof for the space of three months. With- 
out waiting for the averages to do this, it is time to 
sell securities after these monthly average prices of pig 
iron have risen more than $10 from the lowest of the 
previous bear movements in iron. In other words, 
such a rise in pig iron reflects so great an increase in 
the general prosperity that any further substantial in- 
crease is very unlikely. Hence it is that stock prices 
are not likely to go much if any higher, and that it is 
time to sell unstable securities in preparation for a 
bear movement. 

Interest Rates: Whenever the monthly averages 
of New York interest rates as defined above rise above 
5.8 per cent., and stay there for two months — meaning 
two in all and not three — it is time to sell securities. 
However, some bear movements are not foreshadowed 
by such a rise in interest rates. This is true, for ex- 
ample, of that of 1910. The boom of 1909 consisted 
largely of fictitious prosperity rather than genuine well 
being, and was brought about by an era of extravagance 
rather than of large profits and universal employment. 
Hence several of these indications should be used to- 
gether instead of using any one of them singly. 

Bond Prices: When the above defined monthly 
averages of bond prices have sagged as long as three 
months, and at least \y 2 points in face of a very strong 



How and When to Buy and Sell 319 

and active stock market and a boom in general business, 
it is time to sell unstable securities. The underlying 
principle of this generalization has already been noted. 
Distribution: Distribution means realizing by the 
wealthiest of security holders, especially in stocks. It 
is indicated by failure of the stock market to make 
much net advance in spite of enormous activity and the 
wildest optimism. The investing public is always un- 
duly impressed with large share transactions, and 
therefore when insiders want to sell out they make 
the market very active. For this reason during the 
four or more months when prices are at the top or 
are constantly returning to within five points of the 
top, the average monthly sales on the New York ex- 
change must surely exceed 16,000,000 shares and prob- 
ably 20,000,000 shares. The stock price averages after 
having first reached the approximate high level, and 
after having reached $3 therefrom, must fail for at least 
three consecutive months to get above that level by as 
much as three points. After having declined at least 
once from the highest level by as much as three points, 
the average must return at least once within five points 
of the highest level. During all this time the news- 
papers, magazines and brokers' circulars will be char- 
acterized by the greatest optimism, our foremost men 
in finance and industry will give no end of bullish 
interviews and prophecies and the man who thinks 
that stocks or junior bonds are at all likely to decline 
will be laughed at as if he were a fool. Such are the 
evidences of inside distribution. It is then time to sell. 



^ 



320 Sound Investing 



These generalizations have purposely been stated in 
rather arbitrary and academic language. Precise limits 
have been set not because they are sure to be correct 
guides in the future, but because they have been correct 
guides during the past twenty years. Probably these 
limits and definitions will make good in the future; 
but whether they do or not it is better in this Chapter 
to make the statements so concrete and definite that 
anyone can interpret them, than to make them so broad 
and general as to render their practical interpretation 
impossible. The Delphic oracle was never wrong be- 
cause it never said anything which could not have two 
or three meanings; and the great majority of financial 
writings have followed the illustrious Delphic example. 
However, the writer would rather assume the small risk 
that these methods of interpretating financial statistics 
may sometime make an isolated failure, than to set 
forth ambiguous generalizations of no value to the prac- 
tical man. 

To be sure this interpretation cannot be made with- 
out work and trouble. The investor, to use it, must 
at least take the pains to keep weekly and monthly 
averages of the prices of pig iron and bonds and of 
the rates for money. He may also advantageously ob- 
tain or keep averages of stock prices. All this takes 
time on the part of himself or his employes; but no 
one has yet discovered a method of making money 
without labor or pains. By following the policy of 
selling unstable securities around the top of a bull 
movement and repurchasing them around the bottom 



How and When to Buy and Sell 321 

of a bear movement, the investor will not only enor- 
mously increase the safety of his principal, but will 
also increase his average yield by a very large amount. 
The profit should be worth the trouble. 



M 



XLIII 

The Question of Yield 

HOW high a yield the investor should expect is 
often an important question. Especially is 
this true of those not long experienced in 
making investments, and of those who have had the 
misfortune to read the literature of irresponsible finan- 
cial houses, and have thereby obtained the impression 
that very large returns may be secured with practically 
no risk. For these reasons there is here given first, the 
yields which good securities of various classes may 
reasonably be expected to show, when purchased around 
the approximate bottom of a bear movement; and 
second, those which they may be expected to show 
if bought around the top of a bull movement. 

Security At Low Level At High Level 

United States government bonds 2 to 5>£ 1^4 to 3 

State bonds 3y 2 to 4^ 3$i to 4*4 

Foreign government bonds 4 to 6% 3^4 to 5%. 

Municipal bonds 4y 2 to Sy 2 4 to 4}£ 

Railroad mortgage bonds 4$i to 5}i 4% to 4$£ 

Gas and Electric Light Co. bonds... 4Y% to 5^ 4^ to SH 

Equipment trusts 5 to 6 4^ to 5 

Street railway bonds 5 to 6$i 4 J / 2 to S^i 

Steel and Iron company bonds 5}i to 6% 4 T / 2 to Sy 2 

Short Term notes 5^ to 6% 4^ to 6 

Bank stocks 4 to 4$i 3 J / 2 to 4^ 

Railroad junior bonds 4^4 to 6 1 /* 4^ to Sy 2 

Convertible bonds 4Y% to Sy 2 4% to 5 

Equipment mTg company bonds 5 to 6^ 4y 2 to 5^4 

Manufacturing company bonds 6 to 7 5j4 to 6% 

(323) 



324 Sound Investing 



Security At Low Level At High Level 

Copper company bonds 6 to 7j4 3 to 5j£ 

Coal company bonds 5 to 6j£ AY 2 to Sj4 

Light and Power preferred stocks.. 5^4 to 7 5 to 6 

Railroad preferred stocks 5^4 to 6^4 4^6 to 5 34 

Street railway preferred stocks 6 to 7 4^4 to 6 

Industrial preferred stocks 6J4 to 7j4 5 to 6j^ 

Mill stocks 5 to 6 AY% to 5J4 

Railroad common stocks 6J4 to 7j4 5^ to 6}4 

Industrial common stocks 6Y 2 to 7j4 Sj^ to 6% 

Copper company stocks 6}4 to d>% 6 to 8 

These figures are of course mere approximates. 
Changes are continually taking place not only in the 
price of capital itself, but also in the character and 
investment position of various classes of securities. 
For illustration: It is here assumed that good light 
and power company preferred stock may be bought in 
a bear movement at prices which will show a return 
of 5% to 7 per cent, on the investment. Really first 
class seasoned securities do not usually show such re- 
turns, but light and power company stocks are not 
seasoned. 

The public utility companies are the most youthful of 
any large class of companies in the United States. As 
a general rule their preferred stocks have not yet ac- 
quired a fixed status either in the architecture of the 
company or in the estimation of investors. That is, 
many of these preferred stocks are issued by holding 
companies, and have behind them assets which have 
not yet developed stable value. These assets consist of 
the stocks and the properties of rapidly growing sub- 
sidiaries. But if during the next few years these 



The Question of Yield 325 

companies keep on progressing, and the subsidiaries 
keep on consolidating with the parent concerns, the 
position of the stocks will become entirely changed. It 
will then become quite impossible to buy good stocks of 
this class, even in a bear market, that will yield much 
over 6 per cent. 

The question of yield in a final analysis must always 
be an individual question. It cannot be stated posi- 
tively that all yields over a specified figure denote bad 
investments. However, in deciding this question the 
investor is greatly helped by continually bearing in mind 
the following general principles as to yields. 

Five per cent, may be taken as the genuine price of 
capital, and anything one receives over 5 per cent, may 
be regarded as payment for the risk he assumes; while 
anything he receives under 5 per cent, may likewise 
be regarded as the premium upon the credit of the 
borrower. Otherwise expressed, 5 per cent, is the 
proper interest payment to the man who lends to a 
corporation whose credit is sufficiently high so that 
there is practically no risk of principal. A 5 per cent 
return ought to bring the investor a security which is 
about as safe as an account in a typical bank, trust 
company or savings bank. 

In the case of a 6 per cent, return, the investor 
should consider that he receives 5 per cent, for the use 
of his money and 1 per cent, for the risk he assumes; 
and in the case of a 4 per cent, return, he should con- 
sider that he receives 5 per cent, for the use of his 



326 Sound Investing 



money, but gives back to the creditor corporation the 1 
per cent, in return for a sort of an absolute guarantee 
that there shall never be any loss of principal. Of 
course he does not in fact receive the 5 per cent, and 
give back the 1 per cent., but this is an intelligible way 
of looking at the matter. Furthermore the general 
principles as here stated will prevent the thoughtful 
investor a great many times from purchasing dangerous 
or positively bad securities because of their high re- 
turns. In yields, as in everything else, something for 
nothing is not to be obtained. 



XLIV 

Uses of Securities 

THE ordinary uses of securities are understood by 
nearly everyone. These uses are to hold as 
investments; to hold temporarily as a specula- 
tion; to hold as a cash equivalent or a reserve fund; 
to leave to posterity or to institutions ; to hold as a sub- 
stitute for a savings bank account, and to hold 
temporarily as a means of offsetting the average depre- 
ciation in bonds. What classes of securities to use 
for all these various purposes are indicated in the fol- 
lowing tabulation: 

(A) Cash Equivalent or Reserve against Trouble or Stress 

United States Government Gas & Electric Light Mort- 
bonds gage bonds 

State bonds Equipment Trusts of stronger 

Best Foreign Government roads 

bonds Underlying Street Railway 

Best Municipal bonds bonds 

Genuine Railroad Mortgage 
bonds 

(B) Permanent Investments but not Cash Equivalent 

High Yield Foreign Govern- Street Railway bonds 

ment bonds Steel and Iron Company 
High Yield Municipal bonds bonds 

Railroad Second Mortgage Best Short Term Notes 

bonds Railroad Junior bonds 

Good Gas & Electric Light Equipment Manufacturing Co. 

bonds (which are not first bonds 

mortgages) Best Manufacturing Company 
Equipment Trusts of weak bonds 

Roads 

(327) 



328 



Sound Investing 



(C) Temporary Investments to 

Junior St. Ry. & Gas & Elec. 
Co. bonds 

Second Grade Steel and Iron 
Co. bonds 

Second Grade Short Term 
Notes 

More Promising Bank Stocks 

Railroad Debentures & Con- 
vertibles 



hold for High Yield or Profit 

Manufacturing & Industrial 

Co. bonds 
Copper Mining bonds 
Coal Company bonds 
Best Preferred Stocks of all 

classes 
Best Mill Stocks 
Very Best Railroad Common 

Stocks 



(D) Profit-Making Investments to hold Only During Bull 

Movements 



Any Bonds yielding over 6% 
Any Stocks yielding over 7% 
Manufacturing Company 

bonds 
Copper Mining Bonds 
Dividend-paying Industrials & 

Coppers 



Any except very best pre- 
ferred stocks of all 
classes 

Any Mill & Railroad common 
stocks except very best 



(E) Pure Speculations to hold Only for an Advance in Price 



Any and all bonds yielding 
over 6% 

Any and all stocks yielding 
over IVitfo 

All Bonds and Notes in de- 
fault 



All Copper stocks 

Majority of Gas, Elec. Lt, 
Power and St. Ry. com- 
mon stocks 

Vast Majority of Industrial 
common stocks 



All the investment principles and ideas contained 
in this Chapter may be garnered from the previous 
Chapters of the Book, but for the service of busy men 
who have no time to read they are here gathered to- 
gether in brief form. The purpose of this Chapter is 
to show in the shortest possible space the best uses 
of all^-he leading classes of securities. As a substitute 
for investments in real estate the first three classes, 



Uses of Securities 329 

and sometimes the fourth, may be bought and held 
with good success. As a broad general rule, real estate 
which yields as much as bonds is not so safe. Further- 
more, its holder is subject to taxation and to all sorts 
of charges, whereas the holder of many securities is 
free from taxation to a very great extent. 

As a cash equivalent or reserve fund against times of 
stress and trouble Class A of these securities is excel- 
lent. The securities belonging to this class can readily 
be used in obtaining loans even in times of panic. The 
holder need never dispose of them, and need never 
have any trouble in borrowing on them. If he holds 
real estate or some other form of property in a time 
of panic, it would be practically impossible to negotiate 
a mortgage, but such high grade collateral as Class A 
can be taken to any strong bank and used as collateral 
for a loan in a very few minutes. This class of securi- 
ties, then, is a sort of cash equivalent, and can be 
used at all times as a substitute for cash — whereas it 
has the advantage of yielding 4 per cent, or more, 
while the cash itself or its equivalent in bank deposits 
yield only 2 or 3 per cent, unless it be a small savings 
account. 

Classes C and D of these securities are extremely 
useful for offsetting the depreciation in bonds. All 
bonds, taken together, show a substantial average de- 
preciation. Since 1905 the average price of 25 high 
grade mortgage bonds has declined from 99 to 82; 
and even before the war started the average [ -ice was 
only 85. The investment lists of practically all banks, 



330 Sound Investing 



trust companies, corporations, institutions and estates 
show depreciation equal to or greater than that here 
indicated. Hence it is very desirable toward the close 
of bear movements in stocks to purchase such securities 
as Classes C and D to hold temporarily as a means 
of making profit enough to offset this depreciation. To 
hold them permanently, however, merely makes the 
depreciation greater. 

For speculation Classes D and E are the most useful, 
and the latter should be used for speculation only. 
Those who cannot interpret from actual statistics with 
approximate correctness enough to buy when prices 
are below average, and those who are not mentally inde- 
pendent of the whirl of speculative sentiment in times 
of great prosperity, should never buy any of the securi- 
ties mentioned in Class E. This whirls leads only to a 
fool's paradise and to heavy losses, and it does require 
independence of judgment to sell out right in the midst 
of such a boom as always marks the top of a bull 
market. Everyone must be his own judge as to whether 
or not he has the amount of judgment to enable him 
to successfully handle these speculative bonds and 
stocks. 



XLV 

Anatomy of Annual Reports 

FREQUENT references have been made in these 
Chapters to the showing which should be made 
by a railroad, industrial or public utility com- 
pany, in order to render its bonds attractive. It has 
been mentioned, for example, that the margin of safety 
should not be too narrow; and to understand what is 
meant by margin of safety one must have some knowl- 
edge of corporation reports. Moreover, in these days 
when there is such a considerable minority of com- 
panies which make up their reports in unusual forms, 
seemingly for the purpose of making them appear 
better than they really are, this knowledge, though 
elementary, must be exact and discriminating. 
Volumes have been written on the subject, but it is 
surely worth the while of almost any investor who has 
not already familiarized himself with it to read a 
short summary. 

Hence there is here given a generalized form of 
income account and balance sheet which applies to any 
corporation. The particular names of many of the 
items of course vary according as the given company 
is a railroad, street railway, public utility, manufactur- 
ing or telephone company. Nevertheless, the items 
which all should show have a fundamental similarity, 

(331) 



332 Sound Investing 



and to understand one is to understand all sufficiently 
for the purposes of an investor. The numbers here 
given refer to numbers in the following comments, and 
in each case the attempt is made to define the item and 
give a brief statement of its significance, especially as 
related to the buyer of stocks and bonds. 



ANATOMY OF A CORPORATION REPORT 

Income Account 

I. Gross earnings or income: 

2. Subdivision of same by sources: 

Railways : Freight, passenger and others 

Industrials : By products sold 

Public Utilities: Transportation, power and light 

3. Operating expenses : 

4. Subdivision by purposes of outlay: 

Railways: Maintenance, transportation, etc. 
Industrials: Maintenance, depreciation and pro- 
ducing costs 

5. Net operating income: 
6. Other income: 

From investments 
From various sources 

7. Total net income 

8. Fixed charges: 

9. Interest on funded and other debts 

10. Taxes 

11. Payments to sinking, depreciation and other funds 

12. Surplus for dividends: 
13. Dividends paid 

14. Appropriation for construction or improvements 

15. Surplus carried forward 



Anatomy of Annual Reports 333 

Balance Sheet 
Assets 

16. Property account: 

17. Physical property such as road equipment or plants 

18. Franchises, patents, good-will, etc. 

19. Securities owned. 

20. Current assets: 

21. Bills and accounts receivable 

22. Materials, supplies and unsold goods 

23. Cash and call loans 

24. Marketable (uncapitalized) securities 
25. Other and miscellaneous assets: 

26. Advance payments and advances to subsidiaries 

27. Cash and securities in sinking and other funds 

28. Deferred debit items 

Liabilities 

29. Capitalization : 

30. Common stock 

31. Preferred stock 

32. Funded debt 

33. Securities of subsidiaries in hands of public 
34. Current liabilities : 

35. Bills and accounts payable 

36. Unpaid taxes, interest, vouchers, wages or dividends 

37. Accrued taxes, interest or dividends not due 

38. Temporary loans. 

39. Liabilities of company to its owners: 

40. Reserves for depreciation, insurance, pensions, dam- 

ages, etc. 

41. Appropriated surplus for improvements, construction 

and property 

42. Undivided surplus 

1. "Gross income" is useful in showing the growth 
of the given concern; and variations in gross, especially 



334 Sound Investing 



in times of depression, give an idea as to the relative 
stability of earnings. Other things being equal, the com- 
pany which shows the most rapid and steady increase 
in gross income is in the strongest position. 

2. In the case of railways the principal subdivisions 
of gross earnings are freight and passenger earnings; 
and except for companies receiving unusually high pas- 
senger fares, the smaller the percentage of passenger 
earnings the better off the company is, because the 
freight business is the more profitable. Industrial com- 
panies seldom report the sources of their gross income, 
but some of them, like the Steel Corporation, state the 
products sold; and to one who knows something of the 
margin of profit in these various products such state- 
ments are valuable. With public utilities gross income 
from the sale of power and light is more valuable than 
that from the sale of transportation, since it costs less 
to operate lighting and power plants than to operate 
transportation properties. Power and lighting plants, 
as a usual thing, may safely be capitalized at nearly 
six times their yearly gross income, whereas trans- 
portation properties should ordinarily not be capitalized 
for more than five times their yearly gross. 

3. "Operating expenses" generally tend to display 
efficiency of management and variations in the margin 
of profit. These points are brought out by finding the 
percentages of expenses to gross earnings, and com- 
paring them over a series of years. However, it should 
be borne in mind that expenses per unit of quantity 



Anatomy of Annual Reports 335 

of business done are the lowest when the quantity of 
business is normal, and that they tend to rise rapidly 
when business falls below normal, and to rise slowly 
when business increases above normal. Variations from 
these tendencies are not encouraging. 

4. The principal items of railway expenses are 
maintenance of way, equipment and structures, and con- 
ducting transportation. Large outlays for the former 
tend to benefit the property by more than making good 
the wear and tear; but large outlays for the latter are 
indications of inefficiency or ill fortune, since money 
spent for transportation goes into wages, fuel and the 
like, and is utterly consumed so far as the road is con- 
cerned. In determining whether or not a given com- 
pany spends enough on maintenance, the best off-hand 
method is to compare the total maintenance with the 
total volume of traffic, obtaining a ratio between the 
two; and then compare this ratio with that of other 
standard roads having a similar kind of traffic. If 
maintenance expenses per mile of road are used in 
forming a judgment comparisons must be made only 
between roads having a similar traffic and a similar 
density of traffic. 

Industrial companies' expenses consist principally of 
producing costs and of maintenance and depreciation. 
Most such companies state their expenses in very poor 
form, so that the investor has to be guided less by 
their annual reports and more by the personnel of the 
management. A properly managed industrial concern 



336 Sound Investing 



not only spends enough for maintenance to keep its 
physical properties in repair, but also pays into a de- 
preciation fund out of earnings each year enough 
additional to fully cover that depreciation which has 
occurred during the year, but which has not necessi- 
tated repairs. 

5. "Net operating income" is the income from the 
productive or commercial business of the company, 
as distinguished from its income from investments and 
miscellaneous sources. It is obtained by deducting 
operating expenses from gross earnings, and the per- 
centage of this net income to gross earnings should 
represent the gross margin of profit. 

6. "Other income" is principally from investments, 
and these investments usually are not pure investments 
owned for their yield, but represent the interests of the 
parent company in its affiliated or subsidiary com- 
panies. 

7. "Total net income" is the sum of operating and 
other income; but in some cases this so-called total 
does not really include the entire income. Quite a 
number of subsidiary companies pay to their parent 
concerns only their regular dividends or rentals, and 
retain their undivided surpluses in their own treasuries. 

8. "Fixed charges" include all expenses other than 
operating expenses. They consist principally of taxes, 
interest on the funded and other debts, and payments 
into sinking, depreciation and reserve funds. 



Anatomy of Annual Reports 337 

9. The principal significance of interest payments is 
their relation to the funded and other debts of the 
company. By finding the percentage one may learn 
approximately what average rate of interest the concern 
is paying for its borrowed capital. 

11. "Payments into sinking, depreciation and other 
reserve funds" are seldom stated clearly; and such 
statements as are given are usually so incomplete 
and indefinite that it is dangerous to draw conclu- 
sions from them. 

12. The "surplus for dividends" is the total net 
income, minus the fixed charges. In scrutinizing it the 
points to make sure of are: First, that maintenance and 
repairs have been properly attended to; second, that 
depreciation charges have been sufficient to cover the 
actual deterioration; and third, that other income in- 
cludes the entire undivided surpluses of the subsidiaries. 
Sometimes, too, a company omits to charge its entire 
interest against earnings, and carries a portion in the 
balance sheet as a liability. 

14. "Appropriations for construction, property pur- 
chases and improvements" are properly made out of 
that portion of the surplus earnings which remains after 
the payment of dividends. However, they are some- 
times improperly added into fixed charges, — though it 
should not be forgotten that they may be so added in 
with propriety when they represent a sort of deprecia- 
tion charge, 



338 Sound Investing 



15. What remains after such appropriations is the 
final "surplus to be carried forward" and added to the 
"undivided surplus," which is Item 42. If this un- 
divided surplus is genuine, any increase in it will 
usually be accompanied by a corresponding gain in the 
excess of current assets over current liabilities. 

16. Coming now to the balance sheet, the "property 
account" should include all the tangible property owned 
which is of a permanent form. 

17. The term "physical property" explains itself, 
but bookkeeping items covering it are very deceptive. 
It is a common practice to greatly overvalue plants and 
equipment, and in some cases the overvaluation runs 
from one to two or three hundred per cent. Where 
the approximate true value of physical property can 
be obtained, it is significant to find the percentage of 
maintenance and depreciation charges to the same; for 
this percentage then shows whether the properties are 
being maintained without deterioration. 

18. Some companies, instead of inflating the physi- 
cal property valuation, offset the water in their capital 
stock by marking up the book values of franchises, 
patents, good-will, etc., enough to match it. In esti- 
mating the value of the stock, this intangible property 
may practically be regarded as worthless, except where 
the franchises confer actual monopoly privileges. Even 
valuable patents frequently fail to cause the bonds and 
stocks of a company to sell for an aggregate price over 



Anatomy of Annual Reports 339 

and above what they are worth upon the basis of assets 
and earning power. 

19. "Securities owned" are very often immensely 
overvalued, and sometimes represent nothing more than 
separately incorporated branches of the business which 
at the moment are so uncertain that the parent com- 
pany prefers not to assume their liabilities. 

20. "Current assets" are "current." That is to say, 
they are assets whose form is constantly changing in 
the natural course of business and the excess of these 
over current liabilities represents the company's net 
working capital. The principal items in current assets 
were mentioned in Number 20 in the form herewith 
presented. 

21. "Bills and accounts receivable" are usually to 
be accepted at their face value, but in the case of a 
holding company which does not give the consolidated 
balance sheets, its accounts receivable may include 
amounts due from its subsidiaries. Such accounts are 
valueless unless the subsidiaries are rich enough in net 
current assets to be able to turn the money over to the 
parent concern. Otherwise, it is simply a case of one 
pocket owing the other. 

22. "Materials and supplies" as given in balance 
sheets involve ambiguity, unless the reports state at 
what price they were inventoried. They should be in- 
ventoried at cost, provided the cost does not exceed 
the current market value. It sometimes occurs that 



340 Sound Investing 



supplies are not worth their face value because of the 
heavy depreciation which has not been charged off. 

23. "Cash" is always to be taken at its face value 
with all reputable companies. But few companies have 
outstanding any call loans and those which do are 
usually rich concerns so that these loans generally in- 
clude no inflation. 

24. "Marketable securities" is a name under which 
a great many corporations pad their current assets. 
Such securities are almost always acquired by the issue 
of stocks, bonds, or other capital liabilities by the 
owning company. Hence they are not current assets 
in such cases at all. To be current assets they would 
have been acquired and paid for out of surplus earnings 
and not be the issue of capital liabilities. Usually in 
figuring the current assets of a corporation, marketable 
securities should be left out, even though the corpora- 
tion itself may put them in. 

25. "Other and miscellaneous assets" include a great 
variety of items which differ with almost every cor- 
poration. Hence, as a class they cannot well be de- 
scribed. However, three groups of these items are 
mentioned below. 

26. "Advances to subsidiaries" often constitute an 
important item in the case of holding companies. Such 
advances, if the subsidiaries are strong in working 
capital or in earning power, may be considered as a 
portion of the current assets of the parent concern, but 
not otherwise. 



Anatomy of Annual Reports 341 

27. "Cash and securities in the sinking fund and 
other funds" are not usually shown with clearness even 
though they are important. The possession of large 
funds of this account immensely strengthens the finan- 
cial position of any company. 

28. "Deferred debit items" require no explanation. 

29. "Capitalization" consists of the four items num- 
bered 30 to 33 inclusive. Also many corporations have 
short term notes outstanding, and not a few have out- 
standing "notes and accounts payable," which may or 
may not be a portion of the true capitalization. If these 
are merely current accounts payable which are going to 
be liquidated out of surplus earnings, they should not 
be included in the capitalization. But if they are debts 
which are going to be financed through the issue of 
bonds or long term notes they should be included. 

30. "Common stocks" are usually issued not against 
physical property, but against good-will, franchises and 
future earning power and prospects. Therefore merely 
because the capitalization including common stocks ex- 
ceeds the commercial value of a property, does not 
prove over-capitalization, unless the common stock was 
issued for cash and paid for by investors. 

31. "Preferred stocks" are generally issued for 
cash. As a rule these stocks represent mostly tangible 
values such as earning power, but partly physical values. 
It cannot be regarded as conservative for the capitali- 
zation of a corporation, including the preferred stock 



342 Sound Investing 



but not the common stock, to exceed the intrinsic value 
of the property including both tangible and intangible 
values. 

32. The "funded debt" includes not only the out- 
standing bonds of the company, but also its long term 
notes and a great many of the short term notes. If a 
short term note is going to be paid off out of surplus 
earnings it is not a portion of the funded debt, but 
otherwise it is. 

33. "Securities of subsidiaries" or that portion of 
them held by investors should be added in in figuring 
the capitalization of the company. These are often 
very valuable, and in the case of public utility concerns 
they not infrequently represent a substantial proportion 
of the aggregate capitalization. 

34. "Current liabilities" are those liabilities which 
are to be liquidated out of current earnings and receipts. 
The principal items are enumerated below. 

35. "Bills and accounts payable" are hardly ever 
overstated; but in the case of holding companies it 
sometimes happens that these are obligations to sub- 
sidiaries, and may therefore be nominal unless the sub- 
sidiaries owe similar amounts to the public. 

36. "Unpaid taxes, interest, vouchers, wages or divi- 
dends" require no comment; and this is also true of 
Items 37 and 38. 

39. "Liabilities of a company to its owners," or stock- 



Anatomy of Annual Reports 343 

holders, should be sharply distinguished from its liabili- 
ties to the public. The latter must be paid to protect 
the company from insolvency, whereas the former rep- 
resents merely the debt of a corporation to itself. 

40. "Reserves for depreciation, insurance, pensions, 
damages, etc.," may consist of genuine assets held in 
reserve, or it may be a mere bookkeeping item. If 
it represent genuine assets, the company is pretty sure 
to show considerable amounts of marketable securities 
or cash, and is absolutely sure to show a substantial 
excess of current assets over current liabilities. Where 
no such excess is shown one may regard these reserves 
as a mere fiction of bookkeeping. 

41. "Appropriated surplus for improvements, con- 
struction and additional property" is often not shown 
under this name. It is more likely to be carried as 
"final surplus" or "accumulated surplus." Most of 
these surpluses are not liquid assets at all, but merely 
represent the surplus earnings after dividends which 
have been put back into the property. 

42. "Undivided surplus," if it really undivided, 
will always be accompanied by a large excess of current 
assets over current liabilities. If there is no such sub- 
stantial amount of net working capital one may fairly 
conclude that the so-called undivided surplus has act- 
ually been reinvested in the property where it cannot be 
withdrawn, and has thus become a portion of the 
capital assets. 



XLVI 

Feasibility of Successful Speculation 

THERE is no scientific or statistical difficulty about 
accumulating a fortune in Wall Street in the 
course of two or three years through margin 
speculation. Why, then, is it that so few people suc- 
ceed? In this Chapter I shall attempt to show why it 
is, and also to point out the methods by which success 
may be, and sometimes is, achieved. Much is heard 
of this or that individual or firm which has made a 
fortune in Wall Street. The impression gained is that 
the individual concerned has an uncanny knowledge of 
the future through which he has been able to buy at the 
bottom and sell at the top, and thus turn hundreds 
into millions. 

Probably 99 per cent, of the fortunes made in specu- 
lation are achieved not through margin trading in stocks, 
but rather through speculating in properties. The 
process consists of buying up mining lands or industrial 
plants or other properties and capitalizing and selling 
them. However, the securities issued against such 
properties usually exceed the costs of the properties 
themselves by 50 to 300 per cent. Hence the controlling 
interests can sell enough of these securities to reim- 
burse them for the entire cost of the properties, and can 

(345) 



346 Sound Investing 



still hold enough to control the companies. In this 
way fortunes are, and always can be made, but if the 
same individual were to undertake margin speculation, 
he would almost always certainly fail. 

Speculation in properties is perfectly simple to men 
or syndicates having the necessary means. It is needful 
only to find properties which under good management 
are capable of making substantial profits, and where 
there is enough money for development purposes this 
is not especially difficult. The next step is to consoli- 
date these under a single corporation and secure the 
support of a syndicate of banks or bond houses to float 
the securities. Bonds are issued only for the actual 
values of the tangible and intangible assets, and pre- 
ferred and common stocks are issued against earning 
power and future prospects. All these securities are 
readily disposed of to the investing public because of 
the large following which the banks and trust companies 
can command. The management of the company then 
proceeds to develop the earning power, paying divi- 
dends on the preferred stocks and putting value behind 
the common stock. By doing this and keeping in- 
vestors satisfied, the operation can be repeated. Such 
speculation brings wealth to the promoters and gives 
a fair return to investors. 

However, margin trading is totally different. The 
trader is confronted by a vast network of Wall Street 
wisdom crystalized into "axiomatic truths." Most of 
these "truths," however, have no truth in them. Some 



Feasibility of Successful Speculation 347 

of the more important of these axioms are the fol- 
lowing : 

1. When the good news is all out stocks sell off 

2. When the bad news is all out stocks begin to rise 

3. The stock market discounts or anticipates the future far in 

advance 

4. High interest rates cause stocks to decline, and cheap 

money causes them to advance. 

History has demonstrated that all these rules are 
absolutely worthless and yet probably nine-tenths of 
all speculators who are attempting to gauge the market 
by their keenness of judgment are more or less guided 
by them or by other similar rules. The matter of news 
is especially interesting, for the novice feels sure that 
bad news will break the market, and the sophisticated 
trader feels equally certain of the contrary. Let us 
notice how some of the important items of news have 
affected the market. 

In November, 1906, when Hearst was defeated as 
candidate for governor of New York, the market broke 
five points, even though the almost universal assump- 
tion was that it was the Hearst peril that was holding 
the market down. In September, 1908, when the Com- 
modity Clause of the Hepburn Rate Law was declared 
unconstitutional, there was a ten point break, amounting 
for the time almost to a panic, although this was de- 
cidedly good news. In December, 1912, after the an- 
thracite roads won in the Sherman Law suit, there 
was a slight rally and then a big bear movement. In 



348 Sound Investing 



February, 1911, when the Interstate Commerce Com- 
mission rendered its most famous decision in the rail- 
road rate case, there was a slight reaction and then a 
ten point rise. Following the handing down of the 
Standard Oil dissolution decision in May, 1911, prices 
rose continuously for a month and reached the highest 
level of the year. 

These are all instances where the market went con- 
trary to the news, but there are just as many instances 
where it went with the news. For example, it was the 
big war orders and huge export trade that put stock 
prices up so rapidly during 1915. It was the 10 per 
cent, dividend that caused Union Pacific to rise in 1906 
from 140 in July to 195 in September, and it was the 
huge crops of that year that carried the whole market 
up with Union Pacific. The slight money panic in 
March, 1907, broke the prices of leading stocks 22 points, 
and then in the following December and January with 
monetary conditions far worse prices rallied 16 points. 

These illustrations are sufficient to show that the 
market has no definite relation to news of any kind. 
The attempt to acquire wealth through the interpreta- 
tion of the effects of news upon stock prices is absolutely 
futile and always certain to fail. 

Interpretation of interest rates is equally futile. In 
the Gates boom of 1905 stocks once climbed up five 
or ten points a week with call money loaning at 125 
per cent, per annum. On the other hand from May to 
October, 1903, with call money all the time loaning at 3 



Feasibility of Successful Speculation 349 

per cent, stocks were tumbling as if a panic were 
coming. The bear market of 1910 also occurred in a 
time when interest rates were very low. 

Nor does the market anticipate or discount as the 
sages of Wall Street assert. On the contrary stock 
prices are usually a little behind in responding to 
changes in business conditions. As a broad general 
rule, the market goes up and down according as gen- 
eral business throughout the United States is becoming 
more prosperous or more depressed. Instead of antici- 
pating, it follows after. For example, it became cer- 
tain as early as October, 1906, that extremely serious 
monetary trouble was coming, and that this would be 
followed by a severe business depression. But stock 
prices did not break until March and did not reach 
bottom until November 21, after the panic had occurred 
and the improvement had actually begun. The market 
was tardy in starting upon a bear movement, and also 
tardy in starting upon the succeeding bull movement. 

Likewise in the autumn of 1909, huge expenditures 
for improvements, new buildings and the like and an 
era of universal extravagance had produced a sort of 
fictitious prosperity which was certain to collapse. The 
rates of increase in railroad earnings, commodity con- 
sumption and the like were held to be tokens of greater 
and greater prosperity. But in fact these rates were 
so high that they could not possibly be maintained 
unless the average birthrate of the world could be 
doubled to keep up the increase in consumption, and 
the earth could be made to rotate at double speed to 



350 Sound Investing 



supply the products to be consumed. In spite of the 
plain evidence that our fool's paradise was going to 
collapse, stock prices held throughout the balance of 
the year and did not seriously decline until the late 
spring of 1910. It is true that the trend of business 
prosperity is so little understood that changes in it are 
not realized until many months after they occur; and 
yet it is also true that the stock market instead of 
anticipating is usually from one to six months behind 
the changes in business. 

Besides the self-appointed wise men who believe 
they can interpret the news, there are those who expect 
to profit by obtaining "inside information. ,, Such in- 
formation, however, exists mostly in the imagination 
of the inexperienced. It is true that in regard to the 
affairs of individual companies, our financiers and some 
of the directors of the companies, possess valuable in- 
formation far in advance, but this is not exactly what 
is generally meant by inside information. The phrase 
usually bespeaks the belief that our financiers possess 
an advance knowledge of what the stock market is 
going to do and control the movements of the market. 
As a matter of fact, nothing could be more utterly 
silly, for they possess neither the knowledge nor the 
control. The New York Stock market represents prob- 
ably about $20,000,000,000 of corporation securities, 
and there is no man or syndicate of men, or bank or 
combination of banks, which could possibly control the 
movements of the prices of such a vast aggregate. All 



Feasibility of Successful Speculation 351 

the money in the world would be quite insufficient to 
do it. 

Furthermore, the lauded possessors of American mil- 
lions have repeatedly shown that, as a class, they have 
no more foresight than that of humbler citizens. For 
illustration in the autumn of 1906, when Great Northern 
preferred was selling between 300 and 348, or about 
$125 above the greatest real value it ever possessed, 
one of these multi-millionaires, who was a personal 
associate of two of the foremost financiers in the 
United States at that time, went abroad and left orders 
to sell out his Great Northern at 500. He evidently 
expected it would reach that price, but instead it speedily 
sold off to 142, including the market value of the ore 
certificates. 

Another class of speculators attempt to win fortunes 
by means of systems, and systems are the laughing 
stock of Wall Street. Yet they are not nearly so 
absurd as the axioms which Wall Street accepts and 
believes. Chief among these systems are the so-called 
chart method, the tape reading method, studies in the 
volume of transactions and the bond method. The 
chart method consists merely in keeping charts of the 
price movements of stocks, and attempting to interpret 
their significance. The tape reading method, excluding 
certain kinds of tape reading which are based upon 
absurd beliefs that all the quotations are directly con- 
trolled by the inside clique, consists in judging from 
the volumes and prices which way the next movement 



352 Sound Investing 



of the market will be. The assumption always is that 
prices will move down when the heavy volumes come 
out at declines, and vice versa. 

Still others tabulate these volumes by days, months 
and years, and base their conclusions upon the inter- 
pretation of the tables. The bond method of specula- 
tion has as its basis the fact that bond values are more 
stable than stock values, and that therefore the bond 
market usually declines earlier than the stock market, 
and advances somewhat earlier. 

Now the peculiar thing about all these system^ is 
that they are entirely feasible in a scientific way, but 
almost useless in practice. Any one of these systems, 
if it could be followed consistently, would yield the 
speculator a fortune; but it cannot be followed, be- 
cause the psychological difficulty is too great. 

To begin with, the system speculator draws up in 
his mind or on paper certain rules of interpretation by 
which to speculate. He then commences his operations 
with extreme care and a full realization of the diffi- 
culties, and success attends his efforts. By a close 
application to the study of the market, he gradually 
acquires a kind of subconscious perception of the pace 
of the market. This perception at times is truly 
wonderful, for it often enables the trader to unerringly 
pick the high and low points in the price movements 
of his favorite stock, even in a wild market. While 
this strange intuition, which comes at times to all suc- 
cessful traders, lasts, his rules of speculation and his 



Feasibility of Successful Speculation 353 

system of interpreting the statistics of the market fall 
more and more into disfavor with his own mind. He 
is able to see future movements so much more quickly 
than his system shows them, that he becomes com- 
pletely disgusted with the system. He operates by 
means of his intuition or subconscious perception and 
makes thousands where his system would yield only 
tens or hundreds. 

Here lies the psychological difficulty, for it is at 
this juncture that he throws his system overboard and 
trusts to his acute judgment. His success lasts just as 
long as the market maintains the peculiar type of 
action to which he has become accustomed, but sud- 
denly, without being in the least conscious of it, he 
utterly loses this subconscious power of interpreting 
the stock movements. Not being aware of his loss, he 
continues trading, assuming even larger risks than be- 
fore, and the profits disappear faster than they came. 
Success breeds over-confidence, and in a comparatively 
short time even the successful trader finds that he has 
abandoned his system, lost his subconscious foresight 
and lost all his money. 

Now, if he had the power to adhere rigidly to the 
rules of interpretation made by himself, he could un- 
questionably succeed; but it is pretty difficult for the 
mind to create a rule so strong that it can dominate 
that very mind. The creature cannot well be superior 
to the creator. 

All these systems have the merit that they depend 
upon and take advantage of the law of averages. It 



354 Sound Investing 



is not especially difficult to lay down a set of rules 
which would yield so many more profits than losses as 
to produce great wealth; but the psychological difficulty 
is insurmountable to the vast majority of men. Success 
in margin speculation is literally feasible, as is proven 
by the fact that it has sometimes been attained. It 
is feasible, however, only to men possessing ex- 
tremely rare qualities of mind and will; and to ordi- 
nary mortals it is about as easy to succeed in such 
speculation as it is to become a Homer, a Virgil or a 
Shakespeare. 



XLVII 

Bond Incomes 

IT is the conventional thing for books upon bonds 
to give great space to learned discussions of the 
mathematics of bond incomes. The rate of in- 
come is often calculated down to a thousandth or 
even a millionth of one per cent.; but such calculations 
are of scarcely more practical importance to the ordi- 
nary investor than any other problem in higher 
mathematics. Furthermore, these refined calcula- 
tions assume a degree of certainty in bond values 
which is often entirely lacking. Hence it is perti- 
nent to observe several important respects in which 
the theory of bond values differs from the actual 
facts. 

Nearly all bonds of course are redeemable at par 
upon maturity; and if bought above par, they should 
gradually decline while approaching the date of ma- 
turity, whereas if bought below they should gradually 
rise. Furthermore, this advance or decline should in 
theory be so regular that the bond will all the time yield 
the same rate of income on its market price. That is 
to say, an issue which, for example, bears 4 per cent, 
interest, runs 20 years and is purchased at 96 yields 
4.30 per cent., and is supposed to appreciate in price 
just enough to keep the yield constantly at 4.30. 

(355) 



356 Sound Investing 



If all bonds were absolutely secured so as to remove 
the slightest particle of doubt about their redemption, 
and if there were no changes either in the condition of 
the money market or in the general demand for 
securities, and if the supply of new securities was 
always exactly the same — this theory would then be 
true. 

In fact, however, even mortgage bonds of undoubted 
security show substantial variations in both price and 
yield. Instead of approaching par value in exact pro- 
portion as they approach the date of maturity, they 
respond to all sorts of influences. Among these are 
the scarcity or abundance of investment capital, the 
variations in the prevailing interest rates for money, 
the changes in political conditions, the rise and fall of 
corporation earnings and the fluctuating tastes of the 
investing public. 

Largely for these reasons the average price of twenty 
mortgage bonds rose from 88 in December, 1899, to 99 
in April, 1902, and then fell to 86 in October, 1903. 
In March, 1905, these same bonds were up to 99 and 
in November, 1907, the same list, unchanged except for 
the substitution of similar issues for those which had 
matured, showed an average price of 81. By May, 
1909, the price had risen to 94, and in July, 1914, it 
was down again to 83. The variation in the best 
underlying railroad mortgages and in high grade muni- 
cipals is much less than this; but it remains true that 
bond prices do not show the constancy which is as- 
sumed in the elaborate calculations of bond incomes. 



Bond Incomes 357 



A factor of no mean importance is the change from 
year to year in the yield demanded by the public and 
necessarily granted by corporations seeking new capital. 
In 1904 new bond issues generally could be readily 
sold on a 4 per cent, basis; but by 1907 the price of 
capital, by which is meant the return demanded by the 
public, was up above Ay 2 per cent. In 1908 it was 
down to 4%; and from there, there was a rise to 5 
per cent, plus in 1909, a slight fall in 1911 and 1912, 
and a rise above 5 per cent, in 1913. 

Still another factor which prevents bond prices from 
approaching parity by regular stages as the date of 
maturity draws near, is the comparatively small per- 
centage of strictly high grade bonds which have been 
issued especially in recent years. Probably no class 
of corporations in the United States shows better aver- 
age management than the railroads; and yet, according 
to the Interstate Commerce Commission less than 72 
per cent, of the outstanding railroad bonds are mort- 
gage bonds at all, and many of these are second or 
third mortgages. A first mortgage bond responds only 
to investment conditions but a second mortgage or a 
debenture rises and falls with the surplus earnings 
of the given corporation. Municipals, excepting those 
which are very high grade, likewise change in price 
according to the financial condition of the issuing 
municipalities. 

Convertible and debenture bonds continuously 
fluctuate according to earnings rather than theoretical 



358 Sound Investing 



values; and this is true even of some bonds which are 
so well secured that upon their merits they ought to 
show greater stability. The bonds of industrial and 
manufacuring companies are much less stable than 
those of railroads, and often show considerable varia- 
tions in price even when the date of maturity is not far 
away. 

In addition, the buyer must consider the chances that 
he may not hold the bond to maturity; and with an 
issue selling below par the yield he actually obtains in 
such an event is very apt to be substantially less than 
that indicated by the bond tables. For instance, an 
issue selling at 88^2 bearing 4 per cent, and running 
15 years, yields 5.10 if held to maturity; but if held 
only a short time and sold at the same price it was 
bought it yields only 4.52. Thousands of investors by 
looking merely at the bond tables, and forgetting the 
possibility that they might not hold to maturity, have 
deceived themselves into supposing they were getting 
a yield quite in excess of that which they actually 
obtained. 

The fact is that a considerable proportion of all 
bonds are taken out of tin boxes and sold before they 
reach maturity. This may be seen by comparing the 
total yearly bond sales in the United States, excluding 
new issues, with the aggregate par values of all out- 
standing bonds. This aggregate as of 1914 may be 
estimated approximately as follows: 



Bond Incomes 359 



Railroad bonds— net in hands of public $10,309,553,300 

Street railway bonds 2,329,221,800 

Manufacturing and industrial company bonds. . . 4,594,452,000 

Gas company bonds 455,768,800 

Other public utility bonds 1,847,206,300 

Miscellaneous bonds 500,000,000 

Total ,.,,, , $20,036,202,200 

Meanwhile the yearly bond sales, excluding new 
issues, reach a very large total. Sales on the various 
stock exchanges alone exceed $700,000,000 a year, and 
in addition to this all good bond houses resell for 
their customers a considerable proportion of the bonds 
previously distributed amongst them. One large New 
York house in a single year thus re-sold $20,000,000 
of bonds, whereas the annual sales of new issues by 
this particular house amount to only about $100,000,000. 
Many of the sales on the exchanges are no doubt 
semi-speculative, but even leaving them out of account, 
the amount re-sold in the United States in a year is 
probably not less than $888,000,000. 

At this rate it would take but 23 years for all the 
bonds in the United States to change hands, whereas 
the typical bond runs about 40 years. The average 
tei.~» of 100 important issues selected at random from 
the flotations of the past three years was 39 years. It 
is therefore apparent that there is a very large chance 
that the investor will not hold his bond to maturity; 
and considering, in conjunction with this fact, the other 
important fact that he is more likely to be obliged to 
sell it in bad times when prices are low than in good 



360 Sound Investing 



times — it is plain that he should consider the current 
yield as well as the yield if held to maturity. The two 
are often a quarter to a half a point apart, and are 
sometimes a full point apart. 

Those who every month invest thousands of dol- 
lars in bonds naturally require a good set of bond 
tables, but those who do not can readily obtain the ap- 
proximate yield or income basis by a simple arithmetical 
calculation described below. Such a brief arith- 
metical method is necessarily lacking in scientific 
accuracy, as the problem is a complicated algebraic 
one. By way of illustrating the amount of error 
which it sometimes shows, the following compari- 
sons are made of the yields as estimated by this 
method with the yields obtained from the bond 
tables prepared by Montgomery Rollins. 





Inter- 






*r-- Above Method » 

Approx- 




est 


Matur- 


Yield per 


imate 


Decimals 


Amount 


Price 


Rate 


ity 


M. Rollins 


Yield 


Dropped 


of Error 


97.68 


5 


18 


5.20 


5.2009 


5.20 


0.000 


87.00 


4# 


14 


5.875 


5.8922 


5.89 


0.017 


86.21 


3 


6 


5.75 


5.7249 


5.72 


0.025 


85.12 


4 


10 


6.00 


6.0034 


6.00 


0.003 


52.60 


3 


50 


6.00 


5.9807 


5.98 


0.019 


54.70 


3 


40 


6.00 


5.9335 


5.93 


0.067 


72.32 


4 


30 


6.00 


6.0388 


6.04 


0.039 


100.38 


3 


4 


2.90 


2.8989 


2.90 


0.001 


107.07 


4 


8 


3.00 


3.0003 


3.00 


0.000 


109.03 


6 


22 


5.30 


5.3078 


5.31 


0.008 


113.94 


4y 2 


12 


3.10 


3.1014 


3.10 


0.001 


146.80 


6 


20 


2.90 


2.8763 


2.88 


0.024 


156.37 


6 


30 


3.10 


3.1322 


3.13 


0.032 



Bond Incomes 361 



TO FIND INCOME BASIS. 

(A) Select from the compound interest table on 
the opposite page the interest on $1.00 for the given 
number of years at the given rate; and multiply this 
by the price of the bond to obtain the "divisor". 
Retain in the latter only three decimal places at the 
right of the decimal point. 

(B) Obtain the "difference" between the price of 
the bond and parity (100); and multiply this difference 
by the rate of interest the bond pays on its par value 
in order to obtain what is here arithmetically termed 
the "dividend". See that there are seven decimal places 
to the right of the decimal point. As bond prices are 
quoted in eighths, it may be observed that }i is equiva- 
lent to .125; ji to .25; ft to .375; */ 2 to .5; ft to .625; 
Y$ to .75; and % is equivalent to .875. 

(C) Divide the said "dividend" by the said "divisor"; 
and treat the "quotient" after correcting it as an addi- 
tion to the current yield of a bond selling below par, 
or as a deduction from that of one selling above par. 

(D) With a bond selling above par: — Observe the 
"difference" between the price of the bond and par; 
and cast the eye down the "difference" column in the 
"Correction table" until the number corresponding to 
this difference is found. Opposite this number select 
the "corrector" in the "above par" column, and with 
this obtain the specified percentage of the "quotient". 
Use this corrected quotient. 



362 Sound Investing 



With a bond selling below par : — Proceed in like man- 
ner selecting from the "below par" column. Diminish 
the "quotient" by the specified percentage of itself, and 
use the quotient thus corrected. 

(E) Find the current yield of the bond by dividing 
its rate of interest with ciphers suffixed by its current 
price, carrying out the answer to four decimal places 
at the right of the point. 

(F) Then subtract from this current yield or else 
add to it the said corrected quotient as has been di- 
rected in paragraph "c". Drop two decimal places 
from the answer thus obtained — correcting the last re- 
maining decimal place to the right — and the result is 
the approximate income basis of the bond. 

Care must be exercised to correctly point off the 
decimal places in all of these operations; and one must 
bear in mind the arithmetical rules that the decimal 
places in the product must equal the sum of those in 
the multiplier and the multiplicand, and that the deci- 
mal places in the quotient must equal the difference 
between those in the dividend and the divisor. In 
working with figures taken from the "correction table" 
it must be remembered that these figures are in per- 
centages or hundredths, and that therefore the decimal 
point must be moved two places to the left. All these 
operations can be shortened, if desired, by using fewer 
decimal places throughout. The following are examples 
of the working of these rules in the cases of bonds 
selling both under and over par. 



Bond Incomes 



363 



Compound Interest Table 



Years 



3% 



4% 



4K% 



5% 



6% 



1 


0.0302 


0.0404 


0.0455 


0.0506 


0.0609 


2 


0.0613 


0.0824 


0.0930 


0.1028 


0.1255 


3 


0.0934 


0.1261 


0.1438 


0.1596 


0.1940 


4 


0.1264 


0.1715 


0.1948 


0.2184 


0.2667 


5 


0.1605 


0.2188 


0.2481 


0.2800 


0.3439 


6 


0.1956 


0.2681 


. 3004 


0.3448 


0.4257 


7 


0.2317 


0.3193 


0.3643 


0.4129 


0.5125 


8 


0.2689 


0.3726 


0.4264 


0.4845 


0.6047 


9 


0.3073 


0.4281 


0.4913 


0.5596 


0.7024 


10 


0.3463 


0.4858 


0.5592 


0.6385 


0.8061 


11 


0.3875 


0.5458 


0.6301 


0.7234 


0.9161 


12 


0.4295 


0.6082 


0.7044 


0.8086 


1.0326 


13 


0.4727 


0.6732 


0.7820 


0.9001 


1.1564 


14 


0.5172 


0.7408 


0.8631 


0.9963 


1.2878 


15 


0.5630 


0.8111 


0.9479 


1.0933 


1.4271 


16 


0.6103 


0.8843 


1.0365 


1.2027 


1.5749 


17 


0.6589 


0.9604 


1.1272 


1.3142 


1.7317 


18 


0.7091 


1.0396 


1.2240 


1.4313 


1.8981 


19 


0.7607 


1.1220 


1.3252 


1.5544 


2.0746 


20 


0.8140 


1.2078 


1.4310 


1.6837 


2.2618 


21 


0.8686 


1.2970 


1.5415 


1.8196 


2.4605 


22 


0.9253 


1.3898 


1.6572 


1.9624 


2.6712 


23 


0.9835 


1.4863 


1.7781 


2.1123 


2.8948 


24 


1.0434 


1.5868 


1.9045 


2 . 2699 


3.1320 


25 


1.1052 


1.6913 


2.0367 


2.4354 


3.3836 


26 


1.1688 


1 . 8006 


2.1749 


2 . 6094 


3.6506 


27 


1.2344 


1.9131 


2.3193 


2.7921 


3.9338 


28 


1.3019 


2.0318 


2.4703 


2.9841 


4.2343 


29 


1.3715 


2.1543 


2.6282 


3.1858 


4.5531 


30 


1.4432 


2.2818 


2.7933 


3.3977 


4.8913 


31 


1.5170 


2.4144 


2 . 9660 


3.6203 


5.2500 


32 


1.5931 


2.5523 


3.1465 


3.8542 


5.6307 


33 


1.6715 


2.6958 


3.3351 


4.0999 


6.0345 


34 


1.7522 


2.8451 


3.5324 


4.3581 


6.4629 


35 


1.8354 


3.0005 


3.7387 


4.6294 


6.9174 


36 


1.9211 


3.1621 


3.9543 


4.9144 


7.3996 


37 


2.0094 


3.3302 


4.1798 


5.2138 


7.9111 


38 


2.1004 


3.5052 


4.4146 


5.5284 


8.4538 


39 


2.1941 


3.6872 


4.6610 


5 . 8589 


9.0295 


40 


2.2907 


3.8766 


4.9288 


6.2061 


9.6403 


41 


2.3901 


4.0736 


5.1986 


6.5709 


10.2883 


42 


2.4926 


4.2785 


5.4807 


6.9542 


10.9758 


43 


2.5982 


4.4928 


5.7756 


7.3569 


11.7051 


44 


2.7070 


4.7147 


6.0840 


7.7800 


12.8832 


45 


2.8191 


4.9456 


6.4062 


8.2245 


13.7287 


46 


2.9345 


5.1858 


6.7430 


8.6915 


14.6257 


47 


3.0432 


5.4357 


7.0954 


9.1822 


15.5773 


48 


3.1655 


5.6957 


7.4638 


9.6967 


16.5868 


49 


3.2914 


5.9662 


7.8490 


10.2383 


17.6597 


50 


3.4211 


6.2477 


8.2516 


10.8072 


18.7941 



364 Sound Investing 


A 4% bond selling at 85.19 
and running 20 years 


A 5 bond selling at 105.91 
and running 25 years 


(A) 

1.2078— from int. table 

85.19— price of bond 

10 8702 
12 078 
003 90 
96 62 4 

102.89 2482 
Use 102.892 as "divisor" 


(A) 
2.4354— from int. table 
105 . 91— price of bond 

243 54 
2 1918 6 
12 1770 
243 54 

257.9332 14 
Use 257.933 as "divisor" 


(B) 
100.00— par value 
85 . 19— price of bond 

14.81— "difference" 
4 


(B) 
105 .91 — price of bond 
100.00— par value 

5.91— "difference" 
5 


59.24 
Suffix decimals, thus using 
59.2400000 as " dividend ,r 


29.55 
Suffix decimal places, using 
29.5500000 as r ' dividend" 


(C) 
102.892 | 59.2400000 | .5757— "quotient" 

51 4460 
7 79400 
7 20244 

591560 
514460 

771000 


(C) 
257.933|29.5500000| .1146-" quotient" 
25 7933 

3 75670 
2 57933 

1 177370 
1 031732 

1456380 


(D) 
5 757 
.094— "corrector" 


(D) 

1 146 

1.032— "corrector" 


23 028 
518 13 

541.158 
6757— "quotient" 
541— "deduction" 

52 16—" corrected quotient " 


2 292 
34 38 
1146 

1182.672 
1183— "corrected quotient" 



(E) 


(B) 


85.19| 4.000000001 4. 6954-" current 


105.91 15.000000001 4. 7209— "current 


3 4076 yield" 


4 2364 J™ 1 * 1 


59240 


76360 


51114 


74137 


81260 


22230 


76671 


21182 


45890 


104800 


42595 




32950 





(F) 
4.6954— "current yield" 
plus 6216— "corrected quotient" 

5.2170 
5 . 22% is estimated yield 


(F) 

4 . 7209—" current yield " 

minus 1183 — "corrected quotient" 

4.6026 
4 . 60% is estimated yield 



Bond Incomes 



365 



Difference 



Correction Table 



Above Par 
Corrector 



Below Par 
Corrector 



1 


100.5% 


0.3% 


2 


100.9 


0.7 


3 


101.5 


1.1 


4 


102.0 


1.5 


5 


102.6 


2.0 


6 


103.2 


2.5 


7 


103.8 


3.1 


8 


104.4 


3.8 


9 


105.0 


4.4 


10 


105.7 


5.2 


11 


106.4 


5.9 


12 


107.1 


6.7 


13 


107.8 


7.6 


14 


108.5 


8.5 


15 


109.3 


9.4 


16 


110.1 


10.4 


17 


110.9 


11.5 


18 


111.7 


12.5 


19 


112.5 


13.6 


20 


113.4 


14.8 


21 


114.3 


16.0 


22 


115.2 


17.3 


23 


116.1 


18.6 


24 


117.0 


19.9 


25 


118.0 


21.3 


26 


119.0 


22.8 


27 


120.0 


24.2 


28 


121.0 


25.8 


29 


122.0 


27.3 


30 


123.1 


28.9 


31 


124.2 


30.6 


32 


125.3 


32.3 


33 


126.4 


34.1 


34 


127.5 


35.9 


35 


128.7 


37.7 


36 


129.9 


39.6 


37 


131.1 


41.5 


38 


132.3 


43.5 


39 


133.5 


45.5 


40 


134.8 


47.6 


41 


136.1 


49.7 


42 


137.4 


51.8 


43 


138.7 


54.0 


44 


140.0 


56.3 


45 


141.4 


58.6 


46 


142.8 


60.9 


47 


143.2 


63.3 


48 


145.6 


65.7 


49 


147.0 


68.2 


50 


148.5 


70.7 



ALPHABETICAL INDEX 



PAGSS 

Analysis of values 39 

Annual reports, anatomy of 331 

Assets behind bonds 40 

Assets, current 333 

Assets, how to estimate 44 

Appraised values 105 

Architecture of public utility companies 163 

Axioms of Wall Street untrue 347 

Bad bonds 105 

Balance sheets, anatomy of 333 

Balance sheets objectionable 162 

Bank stocks, brief description 18 

Bank stocks 119 

Banks, trust companies and insurance companies 231 

Bond incomes 355 

Bond incomes not determinable 355 

Bond houses, high character of 300 

Bond houses, selection of 299 

Bond prices, interpretation of 313 

Bonds, $100, list of 284 

Bonds that are guaranteed 79 

Bonds that slump 105 

Bonds, stability of 129 

Bull and bear movements 33 

Bull and bear movements, end of 310 

Business proprietors and partners, suggestions for 259 

Buying and selling, how done 309 

Cary Act bonds 155 

Cash equivalent 327 

Classes of investors 224 

Clerks and laborers, investment rules for 284 

Clerks and laborers, suggestions for 277 

Coal company bonds 147 

Coal company bonds, brief description 22 

Coal company statistics 150 

Colleges, hospitals and other institutions, suggestions for. 253 

Convertible bonds . . . . 132 

Convertibles and debentures, brief description 19 

Copper consumption 212 

(366) 



Alphabetical Index 367 



PAGES 

Copper metal, fluctuations of 212 214 

Copper mining bonds, brief description 21 

Copper mining bonds 143 

Copper stocks, brief description 30 

Copper stocks 211 

Copper stocks, statistics of 218 

Copper stocks, valuation of 216 

Copper stocks, yields peculiar 215 

Corporation reports, anatomy of 332 

Cotton mill profits 192 

Decline in bonds 129 

Definitions of accounting terms 334 

Depreciation in securities 35 

Desired security, how found 293 

Divisional liens 77 

Equipment company bonds, brief description 20 

Equipment company bonds 135 

Equipment company statistics 137 

Equipment, life of 97 

Equipment trusts, brief description 15 

Equipment trusts 95 

Equipment trusts, increasing security of 98 

Financial reports of states 62 

Fixed charges defined 336 

Fluctuating principle of bank stocks 121 

Fluctuating principle of industrials 208 

Fluctuating principle of securities 54 

Fluctuating principle of U. S. bonds 55 

Foreign countries, incomes of 65 

Foreign governments, finances of 61 

Foreign governments, statistics of 65 

Gas companies, statistics of 86 

Gas and electric light company bonds 83 

Gas and electric light company bonds, valuation of 89 

Government bonds, brief description 12 

Guaranteed bonds 79 

High yield investments 328 



368 Alphabetical Index 



PAGSS 

Income accounts, anatomy of 332 

Income accounts, objectionable 162 

Income basis arithmetically calculated 361 

Incomes of foreign countries 65 

Industrial common stocks, brief description 29 

Industrial preferred stocks 179 

Industrial stocks 203 

Inside information 350 

Interest rates, interpretation of 312 

Investing, personal side of 49 

Investments for high yields 328 

Investments for profit 328 

Investments, management of 33 

Investments, permanent 327 

Investors, classes of 221 

Irrigation bonds, brief description 23 

Irrigation bonds 153 

Irrigation district bonds 154 

Irrigation statistics , , , ♦ , f 157 

Liabilities, current 333 

Light and power preferred stocks, brief description 24 

Light and power preferred stocks 159 

Light, water and power companies, statistics of 85 

Management of investments .........♦.**..». 33 

Manufacturing company bonds, brief description 20 

Manufacturing company bonds 139 

Margin of safety defined 130 

Margin trading 346 

Marketable securities defined 340 

Mill stocks, brief description 28 

Mill stocks 187 

Mills, profits of . m 192 

Mining companies, valuation of 148 

Mining stocks, valuation of . . . 216 

Municipal bonds, brief description 12 

Municipal bonds 6*7 

Municipal bonds, tests of 72 

Municipalities, indebtedness of , 69 

Net earnings, how to test 39 



Alphabetical Index 369 



PAGSS 

One hundred dollar bonds, list of 284 

Ore reserves and valuations 148 

Other government bonds 61 

Other income defined 336 

Permanent investments 327 

Personal side of investing 49, 221 

Preferred stocks, brief description 24-27 

Preferred stocks, gradations of 163 

Preferred stocks, industrial, brief description 27 

Preferred stocks, railroad, brief description 25 

Preferred stocks, street railway, brief description 26 

Preferred stocks, types of 163 

Price movements, bull and bear, end of 309 

Professional men, suggestions for 265 

Public utility companies, statistics of 85 

Publications of value 294 

Quality of bonds 129 

Question of yield 323 

Railroad common stocks, brief description 28 

Railroad common stocks 195 

Railroad earnings, how to estimate 131 

Railroad, industrial and manufacturing companies 237 

Railroad junior bonds, brief description 18 

Railroad junior bonds 127 

Railroad mortgage bonds, brief description 13 

Railroad mortgage bonds 75 

Railroad operating expenses, how influenced 198 

Railroad preferred stocks 169 

Railroad preferred stocks, yield of 172 

Railroad stocks, how to appraise 199 

Salaried people, investment rules for 272 

Salaried people, suggestions for 269 

Seasoned issues, advantages of 294 

Securities, stability of 35 

Securities, types of 11 

Securities, uses of 327 

Selling and buying, how done ,...- 309 

Short term notes, brief description 17 

Short term notes , f ,,,,,,,,., , , • ♦ . . Ill 



370 Alphabetical Index 



PAGES 

Short term note issues 112 

Short term notes, list of 117 

Speculation, feasibility of 345 

Speculative investments 328 

Stability of bonds 129 

Stabilities of securities 35 

State bonds 61 

States, financial reports of 62 

Street railway bonds, brief description 16 

Street railway bonds 101 

Street railway bonds, valuation of 104 

Street railway preferred stocks 173 

Street railway statistics 103, 176 

Steel and iron company bonds, brief description 16 

Steel and iron bonds 107 

Steel and iron company bonds, list of 109 

Stocks and bond dealers, suggestions for 225 

Stocks, industrial 203 

Stocks, industrial, valuation of 205 

Suggestions for banks, trust cos. and insurance cos 231 

Suggestions for business proprietors and partners 259, 260 

Suggestions for colleges, hospitals and other institu- 
tions 253 

Suggestions for professional men 265 

Suggestions for railroads, industrial and manufacturing 

cos 237 

Suggestions for salaried people 269 

Suggestions for stock and bond dealers 225 

Suggestions for trustees and estates 245 

Suggestions for women and dependents 287 

Surplus earnings, how to estimate 131 

Surplus for dividends defined 337 

Time to buy 315 

Time to sell 317 

Trustees, rules for 246 

Trustees and estates 245 

Trustees and estates, suggestions for 245 

United States bonds, brief description 11 

United States bonds 53 

United States bonds, how used 57 

United States bonds, selling basis of 58 



Alphabetical Index 371 



PAGSS 

Uses of securities 327 

Values by appraisal 105 

Values, how to analyze 39 

Wall Street axioms untrue 347 

Women and dependents, suggestions for 287 

Working capital, significance of 183 

Yield, interpretation of 323 

Yield, proper amount 323 

Yield, question of 323 



h 






Isf&v 



